Remember that the endgame is a Greek default

So Germany's Bundestag voted overwhelmingly to expand their contribution to an expanded EFSF to  €440 billion and German's guarantee rises from  €123 billion to  €211 billion. While this step is constructive, it amounts to giving a terminal cancer patient a massage - the long-term results are still the same.

Be careful about getting overly excited about the subsequent rally in risky assets. Damien Reece, writing in the Telegraph, believes that the vote only kicks the can down the road to November because the problem has morphed into something much bigger than originally envisaged:

Unfortunately for the Bundestag members who voted in large numbers in favour of the greater bail-out powers for the EFSF on Thursday, the world has moved on since July 21.

If they thought it was difficult to get this far, all they've done is ratify a solution to a problem that has changed materially in the intervening period. The measures that European countries are agreeing to allow the €440bn fund to buy the debt of distressed European countries such as Greece, give financial help to banks and lend money to cash-strapped governments. To the optimists this all looked very impressive in July. But it looks all very puny now. It's a solution to a problem that no longer exists.

Back in July the eurozone crisis was a multi-billion euro problem. Now it's a multi-trillion euro problem. 

Michael Ridell at Bond Vigilantes posted 10 reasons why the EFSF is not the Holy Grail. The post is well worth reading in its entirety. For me, but the most important ones are:

(4) Legal risk. Investors in EFSF bonds have no understanding of what the money is to be used for (initially investors were told the facility was not to be used for bank bailouts but that looks likely to change). And if an EFSF guarantor reneges on its guarantee then there’s no payback (so if Slovakia pulls out, Germany just ends up guaranteeing more).

(5) Some of the initial guarantors (Spain and Italy) are themselves in trouble and probably need bailing out. If problem (3) is somehow overcome, then that means more EFSF bonds. But then you run into the problem of fungibility. Each EFSF bond has different guarantors, so the first EFSF bond was issued in January to bail out Ireland. Portugal remains to this day one of the guarantors for that particular bond, despite Portugal itself also needing to be bailed out (the two subsequent EFSF issues were to bail out Portugal, of which obviously neither Portugal nor Ireland are guarantors)...

(10) EFSF is not prefunded. Investors need to be persuaded to part with billions of euros to invest in a vehicle with an ever-expanding mandate that lends money to European governments and banks at precisely the time when the market has decided that those governments and banks are insolvent.

Why would any sane bond investor want to buy credit risk riddled EFSF paper without a hefty risk premium? Because someone told them it's AAA-rated?


Engineering the "orderly" default
I came across the headline ‘Orderly’ Greek default could be market positive a few days ago. Apparently, a number of analysts believe that the effects of a Greek default could be contained and therefore market positive.

I call this wishing for Santa Claus scenario. I suppose that if the EU governments were to mount a TARP-style rescue, by making bond holders whole in the manner of the US bailout in the post-Lehman era.

Duh! If Santa Claus came to the rescue then of course that would be market positive.

I continue to favor a Swedish-style bailout of depositors with an upper bound in costs of €800 billion. Under such a scenario, the authorities allow Greece to default. They would then tell the banks: "We know that you are insolvent but we stand ready to backstop you and inject sufficient equity to recapitalize you. If you take our option, then the shareholders will get diluted to virtually zero and bondholders will have to take haircuts. Management will get replaced. No depositor funds will get lost. This plan is not mandatory. You may find a private market solution before coming to us if you wish."

Such a solution would make the market capitalization of the banking sector in the European stock indices go to virtually zero. On the other hand, it be enormously stabilizing for capital markets as risk premiums would come down, though credit risk on European sovereign debt would probably rise.
 
Is that market positive enough for you?

 
Don't forget the endgame
You shouldn't forget what the endgame in the Euro-drama is going to be. Greece will default. It's just a question of when and how.
 
John Hempton sketched out two reasonably credible scenarios for Greece after a default (read it here). There is one for if she left the eurozone and one if she stayed. Neither is exactly a party. To add to the gloomy outlook, even euro area architect and former ECB chief economist Otmar Issing believes that a Greek exit from the eurozone is inevitable.
 
Joshua Brown took notes from a luncheon with superstar bond manager Jeffrey Grundlach. Here are some selected key quotes:

On the Euro Crisis: "I don't know what's going to happen in Europe but there is one thing I am certain about - eventually, someone is going to take a big loss. As investors, the most important thing we can do is to make sure that we aren't the parties taking that loss." He says DoubleLine's portfolios have zero European stocks, zero European bonds, zero european currencies, zero assets denominated in euro currencies - also, zero exposure to US bank stocks.

And here's the one to remember:

On Bull Markets and Bear Markets: If you study history, you'll see that "bull markets are about cooperation, bear markets are about divisiveness." Jeffrey says the Euro common currency came about in 1999 at the very peak of global cooperation, the fact that asset prices peaked around then too is not a coincidence. Right now divisiveness is everywhere and a global bear market is underway.

This is a bear market. Adjust your risk appetite accordingly.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

What's Warren up to?

In commenting on the Berkshire Hathaway share buyback, David Merkel at Aleph Blog extrapolated the buyback to a more general assessment of the stock market [emphasis added]:

As far as buybacks go, this is a good one, but the question remains, how good is it? If Buffett had better uses for cash, he would not be buying back stock, and this is at a time when all equity valuations are depressed.

To me this indicates that Buffett does not have any large places to deploy cash superior to the cost of capital of Berkshire Hathaway, which is pretty low, aside from investments with an inadequate margin of safety.

That doesn’t mean the whole market is overvalued, but it does mean that a bright guy like Buffett anticipates no more large productive places in the near future to put large amounts money to work than by shrinking his own balance sheet. Not a good sign for the economy.

This makes sense to me. Until I remembered that Buffett was quoted in August as saying that the stock market is cheap compared to bonds and he is buying:

In the meantime, Buffett is looking to buy stocks -- oh, and apparently to sell Berkshire bonds too. Berkshire is reportedly taking advantage of record low rates and issuing bonds to raise dirt-cheap capital. For Buffett right now at least, this is not a time for fear. This is a time for action.

Warren Buffett will be the first one to tell you that he is good at spotting value but terrible at market timing. 

So has he changed his mind? What's going on at BRK?



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

BNN interview today at 4pm EST

For my Canadian readers, you can catch me today (Sep 28) on BNN at about 4pm EST today. I will be speaking about Europe.

Here is the link to the video. Come see the violence inherent in the system!



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Europe needs to move faster

Imagine that a fire from a gas-fired barbeque broke out on your condo-apartment balcony. The heat is too intense so you call the Fire Department. The fire fighters arrive, but they don't put out the fire. (We aren't sure if the balcony is stable enough to hold fire fighters so we have to formulate a durable policy for dealing with future fires in this building.) Instead they call the fire inspector.

The fire inspector arrive 20 minutes later. By this time, the fire has spread to your living room. He calls for plans to the building in order to ascertain the structural integrity of the balcony, the location of gas lines and wiring, in order to assess the situation.

An hour passes. By this time, the fire has engulfed most of your condo-apartment. The fire inspector then calls for a summit meeting of stakeholders (unit owners, residents, etc.) in order to come to a consensus on how to best contain the fire...

Does this sound like the EU? Sometimes the slow deliberative process of democracies is the best way of achieving consensus and formulate the best policy to deal with situations. During emergencies, we need someone to take control, now.


The market is waiting for the fire fighters to act, not another summit
Mohamed El-Erian of Pimco recently commented on last weekend's G20 meeting and believes that Europe doesn't have six weeks and waiting until November may be too late:

“They don’t have six weeks,” said Mohamed A. El-Erian, chief executive of Pimco, the world’s largest bond manager. He said fear had reached the very core of the 17-nation group that uses the euro currency, with the price of insurance on German debt rising substantially this week.

The light already is flashing yellow,” Mr. El-Erian said. “They can’t allow it to flash red. You have to give people a vision of what you want the euro zone to look like.”

Simon Johnson, former chief economist at the IMF, recently wrote that the IMF isn't big enough to rescue Europe. Of a greater concern is how s-l-o-w the process is [emphasis added]:

Complaints may be heard this weekend, but there is no one at the IMF meetings who can persuade the key European players to move faster in their decision-making. The politicians will take their own time – prodded periodically, no doubt, by the financial markets.

Do not expect a fast resolution or, therefore, a quick turnaround in the global economy.

 
The fire spreads
The markets may not have the patience for another series of meetings and the long involved process of stakeholder consultations and legislative ratification. Events are spiraling out of control.
 
The latest idea for a levered EFSF faces many roadblocks. The head of the German constitutional court has issued a blunt warning that no further fiscal powers may be surrendered to Europe without a new constitution and a popular referendum. What's more, Angela Merkel faces tremendous opposition to the concept of an enlarged EFSF. Neil Hume of FT Alphaville reports (via BarCap) that:

According to Die Welt, the FDP’s financial spokesman, Otto Solms, argued that any attempt to introduce leverage through the backdoor would lead to the withdrawal of FDP support for the EFSF, as the contingent liabilities for the German taxpayer would rise in an undue fashion.

Moreover, even the main opposition party, the SPD, which so far had signalled its broad-based support for the EFSF reform, has signalled its discontent. The SPD’s speaker on budget issues, Schneider, argued that any introduction of leverage that would not feature explicitly in the EFSF reform bill discussed and voted on this Thursday in the Lower House would be a de facto circumvention of Parliament, and that this would simply be unacceptable to the SPD.

According to the Telegraph, Spanish elections may be on the horizon. (Will that hold up their EFSF ratification vote?)

Spain today called a snap election for November 20. The government is seeking a mandate to push through unpopular reforms, with both parties committed to cuts.

The Guardian reports that on the Tuesday that the Greeks are expected to vote on a revised property tax, the next tranche of aid may be delayed:

Anger with Greece over its failure to properly implement reforms in return for a €110bn bailout from the International Monetary Fund, European commission and European Central Bank in May 2010 led inspectors from the "troika" to abruptly suspend a visit to Athens this month.

Tasked with compiling a crucial review of the country's fiscal progress, it was hoped the monitors would return tomorrow. But continued distrust over Athens's ability "to walk its talk" – despite repeated assertions that it would do "whatever it takes" to rein in Greece's runaway public debt and deficit – has reportedly hampered negotiations. Despite the government's attempt to appease rescue creditors by unveiling a new round of draconian cuts last week, the Greek finance minister, Evangelos Venizelos, received a cool reception at the IMF's annual meeting in Washington last weekend. Christine Lagarde, the body's managing director, insisted that headway could only be made with "implementation, implementation, implementation".

Maybe the Greeks and the markets don't realize how serious this is. The Guardian article went on [emphasis added]:

"I cannot give you any specific date, but certainly, it is very difficult to imagine that [loans will be released] by 3 October," Amadeu Altafaj Tardio, a commission spokesman, said. He refused to be drawn as to why Greece's troika of lenders were delaying their return. Once the mission was concluded, he added, monitors would have to send their findings to other eurozone countries before a decision could be made – a lengthy process that would mean the instalment not being disbursed before the middle of the month at the earliest.

We don't have a lord!
The European saga is starting to sound like the Monty Python farce from The Holy Grail [emphasis added]:

ARTHUR: Then who is your lord?
WOMAN: We don't have a lord.
ARTHUR: What?
DENNIS: I told you. We're an anarcho-syndicalist commune. We take it in turns to act as a sort of executive officer for the week.
ARTHUR: Yes.
DENNIS: But all the decision of that officer have to be ratified at a special biweekly meeting.
ARTHUR: Yes, I see.
DENNIS: By a simple majority in the case of purely internal affairs,--
ARTHUR: Be quiet!
DENNIS: --but by a two-thirds majority in the case of more--

A golden opportunity for traders?
If there are so many obstacles in the way, then why are the markets rallying? Citigroup speculates (via FT Alphaville) that it's portfolio rebalancing by pension and endowment funds:

Remember that this year it has been about a recurrent theme of rallying into the month end which has happened in 6 out of 8 months only to be followed by drastic falls straight afterwards at the beginning of the next month. End of August / September is a great example of this in Europe with the estoxx 50 rallying 8% in the last week of the month only to fall by a similar amount in the next week. Monthly asset allocation into the underperforming asset class?

Specifically [emphasis added]:

•  Large declines in US and global equity markets in August coupled with bond outperformance could see large monthly asset rebalancing by US pension funds- rotating OUT of bonds and INTO stocks. This may have a profound short term impact on risk assets.
•  Here are the monthly results as of Close Of Business 9/22/11. This assumes that the hypothetical portfolio is 60% equities (split 75% into US equities and 25% international) and 40% SBBIG index.
•  The international equities are down 12.6%, the domestic equities are down 7.33%, and the SBBIG index is up 1.68%.
•  This implies a 2.6% rotation out of bonds and into equities. Historically speaking this is quite a strong number, though down from this time last month.
•  It’s interesting to note that last month, on 8/24, the signal was at 2.77% in favor of equities but by the end of the month it had dropped to 2.02%, after equities strongly outperformed bonds in that last week.

If an investor is rebalancing to a fixed asset allocation by selling bonds and buying stocks in the face of these macro risks, then the market action this week represents a golden opportunity for nimble traders to sell into those buyers of risk.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Europe has no way out

I have been thinking extensively about what possible solutions to the European problems. In this post I outline my best case scenario, but as I see it the Europe that emerges out of the financial wreckage is crippled for years to come.

My best case scenario is similar to the plan outlined in the Telegraph over the weekend, though without the leverage. As an aside, the latest news out of Germany where the head of the constitutional court have said that a levered (and possibly even an unlevered EFSF) is out without a referendum is going to be bad news for investors who are looking for a speedy approval of the German EFSF contribution. Notwithstanding that shocker, here are the key elements of my scenario, which does not necessarily depend on the rulings of the constitutional court:

• Greece undergoes an orderly default sometime in the near future.
• In the meantime, the EU and ECB cooperate to keep things together. The EU dispenses the next round of aid to Greece and the ECB supplies all the necessary liquidity to the banking system so that the markets don't panic and cause a bank run.
• On the fateful day of Greek default, many European banks will be rendered insolvent.
• EU governments implement the Swedish solution and nationalize most of the European banking system. They will tell the banks, "We know that you are insolvent but we stand ready to backstop you and inject sufficient equity to recapitalize you. If you take our option, then the shareholders will get diluted to virtually zero and bondholders will have to take haircuts. Management will get replaced. No depositor funds will get lost. This plan is not mandatory. You may find a private market solution before coming to us if you wish."
• The cost of this plan is not insurmountable. I had estimated (see analysis here) that an upper bound for re-capitalizing eurozone banks to be in the order of  €700-800 billion. Not all banks will need re-capitalization nor do they all need all of their Tier 1 capital replaced, so the current size of the EFSF may be sufficiently large for such an operation.

A lot of people will get hurt, but Europe will emerge out of this crisis with a much healthier banking system going forward - as all the bad loans will have been written off and we start with a clean slate.


Greece in or out?
Since my best case scenario is similar to the one outlined in the Telegraph article but without the leverage, I felt compelled to explore it some more. The key question in my scenario is, "Does Greece stay in the euro?"

The Telegraph article answers that question:

As quid pro quo for an enhanced bail-out, the Germans are understood to be demanding a managed default by Greece but for the country to remain within the eurozone. Under the plan, private sector creditors would bear a loss of as much as 50pc – more than double the 21pc proposal currently on the table. A new bail-out programme would then be devised for Greece.

If Greece stays in, then what happens after the re-structuring? John Hempton sketched out a reasonably credible scenario for Greece after a default if she stayed in the eurozone:

Greece has a huge problem after the default - which is that its banks are insolvent. They own a whole lot of Greek Paper. Moreover Hellenic Telecom does not look that great either. [Ed: problem solved as insolvent banks are recapitalized.]

The recession goes from bad to worse and the government deficit goes from bad to worse. The Germans wind up owning the banks and the telephone company as partial offset to their losses lending to them. The Greek Institutions are captured by the Germans. (All your base are belong to us.)

They also wind up getting paid a little more as Greek austerity - as long as it lasts and that might be a long time - partially reduces German losses but at huge social costs.

The Eurozone becomes really dysfunctional - with the whole periphery totally unable to work their way out and having lost all their key institutions to the Germans who neither know how to run them nor really want them.

Moreover Greece stays expensive and unproductive and becomes more socially fractious. The likelihood of them staying the the Eurozone would be pretty low. (After all what have the Germans ever done for me!)

Europe would be held together by a massive and compulsory German aid budget. If they can't get that agreed on on day dot (and Merkel and the German constitutional court are not of that mind) then my guess is that is is in Greece's interest to go the Argentine route and let the rest of Europe fend for themselves.

The endgame is still ugly
What Hempton is in effect saying, "Is the Greek economy sustainable after the re-structuring?"

Let's do some back of the envelope calculations here. Supposing that Greek debtholders take a 50% haircut (as envisaged by the Telegraph article) and debt-to-GDP goes from the 140-180% range to 70-90% range. Since they defaulted, they will have to pay a premium interest rate over Bunds - say 200-300 bps. This puts their adjusted debt-to-GDP in the 80-110% area on a German-equivalent basis. This assumes that Greece will undertake the insanely draconian austerity programs currently imposed by the Troika that are already highly unpopular and politically unpalatable.

Here are some unanswered questions:

1. Where will future Greek growth come from?
2. Will this life of "living dead" encourage future Greek governments, or possibly the Greek military, to do an Argentina and leave the euro? (Also see Hempton's post on Greece's Argentina option and how the contagion spreads to the other periphery countries.)
3. Is this another version of kicking the can down the road for the next generation of European politicians?
4. How will the population of the other periphery countries react to this deal?

While an imminent crisis is averted, there seems to be no good way out of this for Europe.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Another leg down in this bear market?

Last week's post-FOMC selloff was truly breathtaking. There have been several explanations advanced for the decline. My own take is that bearish traders flattened their positions ahead of the FOMC meeting. (The advance in the previous week looked suspiciously like a short-covering rally as the market seemed to rise on bad news.) When the Fed didn't surprise with another round of QE, the bears re-established their positions.

Nevertheless, the sudden selloff has done enormous amounts of technical damage to the markets, which suggests that another leg down is on the way.


European markets are breaking down
Let's start with Europe since the main source of stress comes from there. A glance at the STOXX 50 shows that it has broken down through an important level of technical support. This index seem destined to test the 2009 Lehman Crisis lows.

Is the cavalry on the way?
The good news is that the financial cavalry may be on the way and there may be a bullish trigger to put a floor on this market. Over the weekend, the Telegraph reported that a €2 trillion bailout fund planned to save Euro as Greece faces default:

German and French authorities have begun work on a three-pronged strategy behind the scenes amid escalating fears that the eurozone’s sovereign debt crisis is spiralling out of control.

Their aim is to build a “firebreak” around Greece, Portugal and Ireland to prevent the crisis spreading to Italy and Spain, countries considered “too big to bail”.

According to sources, progress has been made at the G20 meeting in Washington, where global leaders piled pressure on the eurozone to fix its problems before plunging the world back into recession. In a G20 communique issued on Friday, the world’s leading economies set themselves a six-week deadline to resolve the crisis – to unveil a solution by the G20 summit in Cannes on November 4.

Sources said the plan would have to be released as a whole, as the elements would not work in isolation.

Sky News has confirmed the story, according to ZeroHedge:

As well, Bloomberg confirmed elements of the story by reporting that Angela Merkel stating that "euro-region leaders must erect a firewall around Greece to avert a cascade of market attacks on other European states that would risk breaking up the currency area."


Tepid reaction to plan
The initial reaction has been less than enthusiastic. As I write these lines late Sunday, the EURUSD shot up on the news of the plan but has since retreated back into the red.

Mohamed El-Arian of Pimco believes that waiting until November may be too late:

“They don’t have six weeks,” said Mohamed A. El-Erian, chief executive of Pimco, the world’s largest bond manager. He said fear had reached the very core of the 17-nation group that uses the euro currency, with the price of insurance on German debt rising substantially this week.

The light already is flashing yellow,” Mr. El-Erian said. “They can’t allow it to flash red. You have to give people a vision of what you want the euro zone to look like.”

Yves Smith at Naked Capitalism believes that the market may be disappointed by the too little, too late nature of the plan [emphasis added]:

And in another bit of deja vu all over again, the powers that be in Europe are readying yet another bailout plan, this one supposedly big enough to do the trick once and for all. The problem is that was the premise of several of the last grand schemes, such as the EFSF and the ESM. The market calming effect relatively short lived because analysts quickly pencilled out the programs were inadequate in size and failed to address the problems of lack of a fiscal mechanism at the EU level and the need to address the elephant in the room, bank solvency.

The program in the works claims address the underlying issue of bank solvency, but even the sketchy leak of this weekend reveals it falls falls short, both in concept and in size.

The post is well worth reading in its entirety. She agrees with El-Arian's contention that it may be too late:

The Eurocrats are going to be slow out of the gate. They want to launch the plan at the next G20 meeting, which is six weeks away, November 4. Mr. Market doesn’t care about the schedules of the officialdom, and is highly unlikely to wait that long.

In addition, the banking lobby has already come out against any deal that requires them to take a bigger haircut on Greek debt. Mish had a myriad of problems with the plan, the most important of which (which Yves Smith also pointed out) is that it is locking the barn door after the horse has bolted:

Their aim is to build a “firebreak” around Greece, Portugal and Ireland to prevent the crisis spreading to Italy and Spain, countries considered “too big to bail”.

Mish: If that's the plan it, it has failed already. The crisis has already spread to Spain and Italy. In fact, one look at European bank stocks says it has spread to France and Germany as well.

If Italy and Spain behind the "firebreak", then these stock markets are important "tells" of European stress. The Italian market is currently resting on support going back to the 2009 lows. Watch out below if the dam breaks here!

The Spanish market is in slightly better shape than Italy, though it appears to have sliced through several technical support levels like a hot knife through butter. The last test is also the 2009 lows.

My fear is that this plan will fall flat, just like Bernanke's most recent "I've got a secret weapon" speech at Jackson Hole.


Commodities signaling another leg down
What's more worrying is the fact that commodity prices are now breaking down, which tells me that Mr. Market is starting to freak out over the prospects of a synchronized global recession. The chart below shows that the commodity price retreat is on the verge of breaking into a rout.

What's more. The panic downleg, much like the 2008 waterfall decline, has barely begun.

More specifically, economically sensitive Dr. Copper is signaling that the freefall for the entire commodity complex is just starting. As the copper price crashes, what are the implications for China's copper collateral trade and what are the risks to the Chinese official and shadow banking system?

Bespoke's analysis of commodities, shown here, also shows that all commodities are either in downtrends or broken down from uptrends. Some, such as silver, copper and coffee, are already in freefall.

A glance at the currencies of the commodity sensitive countries tells the same story. The Canadian Dollar broke an important support at par and promptly fell 3c in a hurry. Next stop is 95c and 91.6c after that. Note how much it fell during 2008.

The Australian Dollar is showing a similar pattern. It's virtually impossible to know what the downside target is at this point.

Sentiment indicators are not at panic extremes yet
Another class of indicators that I watch is sentiment and sentiment levels are not at capitulation readings yet. The VIX, while elevated, is not at the-world-about-to-end levels consistent with a wash-out. My inclination is to wait for the reaction to a Greek default or European banking crisis, such as the specter of a major European banking such as SocGen losing its funding and going under.

The other sentiment indicator that I watch is the price action of gold and gold stocks. Up until recently, gold prices had been rising in lockstep with financial tensions and so had gold stocks. When the panic selling frenzy engulfs the market and the margin clerks and risk managers take control, all "risky" (read: non-default-free Treasury assets) get sold.

Take a look at chart of the ratio of gold stocks to gold below. The panic selling hasn't even begun and the descent has been controlled so far. Now look at what happened in 2008.

The gold bugs assert that gold is a refuge in a time of crisis. Unfortunately, when the margin clerks take control - fundamentals don't matter.

The last sentiment measure that is problematical for the bullish trade is the behavior of insiders. Corporate insiders had been buying heavily in early August when the stock market began its initial decline. More recently, TrimTabs reported that insider buying has virtually disappeared, literally overnight .


How far down?
The next question for investors must be, "What's the downside risk?"

I could tell you about P/E ratios (when I asked "How cheap are stocks?") and say that the market could conceivably revisit its Lehman Crisis lows. Instead, a better way of approaching the problem is to watch Europe, which is the source of the stress, and watch how European equities perform in the days and weeks ahead.

The importance of European markets holding the 2009 support is illustrated in this chart of the Dow Jones Transportation Average. The Transports are tracing an eerily similar pattern to 2008 - an indexing breaking down after violating an uptrend. What was surprising is the extent the Transports fell afterwards in the panic.

How European stocks behave is the leading indicator of asset market prices this time around.

 
A financial winter is coming, but spring will come
A financial winter is coming but there is no need to panic. Just as spring follows winter, the global economy will heal itself and investors can survive and prosper again. Have a plan to manage your way through such periods of market volatility. With that in mind, I offer the following suggestions:

• Be the predator and not the prey: Food is scarce in winter and predators will take the opportunity to pick off weakened prey. Should the markets panic, asset prices will sell off into unreasonably cheap levels as weakened investors raise cash to meet margin calls, or worse, pay their bills. If you are sufficiently liquid and have sufficient resources, then there will be great opportunities to pick up assets at distress prices as the weak sell to the strong. At the very least, make sure that you are not the weakened prey.
• Store food for the winter: From a tactical viewpoint, either get more liquid or take positions in default-free long-dated US Treasury bonds whose prices are expected to rally from a rush into safe haven assets. A Canadian investor with a long US Treasury bond position has even greater upside potential because the Canadian Dollar is likely to weaken against the US Dollar in such an environment.
• Be opportunistically prepared to buy: Looking longer term, low or negative real interest rates generally signal a friendly investment environment for commodity prices. Continued government and/or central bank accommodative policy responses will likely push real interest rates even lower and add to even more future asset inflation. Investors who are opportunistic or prepared to look over the valley can view periods of market weakness as opportunities to accumulate positions in commodities or commodity producers as a hedge against asset inflation. 

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Dysfunctional Europe, Washington (and now G20?)

Bloomberg reported yesterday that Debt Deal Comes Back to Haunt Boehner in Disaster Aid Fight:

House Speaker John Boehner once again is facing a rebellion of rank-and-file Republicans over spending with a government shutdown looming.

This time it’s a disaster assistance bill that includes a stopgap budget measure needed to keep the government running into next month.

Tea Party-backed freshman and veteran lawmakers helped kill the measure yesterday because they said it spends too much -- a problem for Republican leaders with a bill intended to implement budget levels agreed to last month as part of a compromise to raise the debt ceiling.

This impasse shouldn't be a surprise. Back on August 15, Rex Nutting wrote that the Republicans may be tempted to use their newfound muscle to wrestle a more favorable deal by shutting down the federal government on October 1 [emphasis added]:

While the debt-ceiling agreement did produce a broad outline of how much the government would spend in the next fiscal year, it did not settle any of the details about exactly which line items would be cut, which would be held constant and which would get increases. And, contrary to what most people inside the Beltway believe, the level of spending agreed to in the debt-ceiling agreement is not binding.

Remember, House Republicans have approved a budget that calls for spending about $25 billion less than in the debt-ceiling deal. Republicans could try to extract those larger spending cuts — and more — by threatening to open the new fiscal year with a government shutdown.

They held the government hostage before and they have every incentive to do it again:

Rather than ask if the Republicans would really threaten another shutdown in October, it’d be better to ask why they wouldn’t. Their threats have worked before, and there’s no reason to believe they wouldn’t work again. Once you’ve taken the nation to the edge of default, what’s a mere government shutdown?

Top Republicans have already said that they will continue to use every opportunity to hold the government hostage. The Republicans took us to the very brink, and what they saw when they peered over the edge didn’t shock them or repel them in horror, but encouraged them to do it again.

 
Living in glass houses
Last weekend, Treasury Secretary Tim Geithner was in Poland lecturing the EU finance ministers on the importance of unity in the face of a financial crisis. As we approach October 1, which is the start of the US federal government's fiscal year, Congress could deadlock again and shut down the government.
 
How can a representative the US government have any credibility to lecture others on the importance of unity in the face of a financial crisis?
 
At the same time, I see that the Obama Administration is trying to avert an immiment default by the Postal Service by bailing it out one more time. The USPS is required to make a payment to fund retiree healthcare benefits, money it doesn't have.
 

Adding more cooks at the G20
If the different levels of the US government cannot even do something as simple as fixing the postal service, how can it hope to achieve something as complex as agreeing on multi-trillion budget cuts? Is this illustrative of the kind of political constraints that the financial markets have to operate with? In that case, what hope is there for the eurozone, which has many more actors?
 
Will adding more cooks, as the G20 does, help? The communique was long on rhetoric but short on specifics, according to Reuters:

A U.S. official, speaking after the G20 meeting, said the group showed a heightened sense of urgency but did not discuss a specific mechanism to leverage or expand the bailout fund.

While steps, such as an expanded EFSF, would be tremendously constructive, I see no country or countries stepping up to declare that they, in concert with others, are willing to write a big cheque to help Europe. All I see are denials, such as this one from the BRIC countries:

Earlier on Thursday, the leaders of seven big economies stressed the need to contain the euro zone crisis, and finance officials from the so-called BRICS countries, including heavyweights China, Brazil and India, said they would consider giving more funds to the International Monetary Fund to boost global stability.

But India said developing countries were not in a good position to bail out richer economies and the U.S. official said the G20 had not talked about emerging economies providing the IMF with more funds.

When I read the communique (h/t ZH), I see nothing concrete here for the eurozone crisis:

We are taking strong actions to maintain financial stability, restore confidence and support growth. In Europe, Euro area countries have taken major actions to ensure the sustainability of public finances, and are implementing the decisions taken by Euro area Leaders on 21 July 2011.

Doesn't the 21 July 2011 decision refer to forcing the Greeks to take draconian austerity measures which are becoming more and more politically difficult by the day?

Specifically, the euro area will have implemented by the time of our next meeting the necessary actions to increase the flexibility of the EFSF and to maximize its impact in order to address contagion. The US has put forward a significant package to strengthen growth and employment through public investments, tax incentives, and targeted jobs measures, combined with fiscal reforms designed to restore fiscal sustainability over the medium term.

The "euro area" is having trouble getting its member states to contribute the the EFSF (witness Slovenia). How is that stabilizing? We also saw what the EU minister reaction to the Geithner proposals were last weekend.

The last substantial paragraph of the communique sounds like the standard US Treasury Secretary line: "Our objective is a strong US Dollar":

We commit to take all necessary actions to preserve the stability of banking systems and financial markets as required. We will ensure that banks are adequately capitalized and have sufficient access to funding to deal with current risks and that they fully implement Basel III along the agreed timelines. Central Banks will continue to stand ready to provide liquidity to banks as required. Monetary policies will maintain price stability and continue to support economic recovery.

Coordinated response, indeed!


 
 
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
 
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Markets are signaling an economic downturn

What a day! Notwithstanding the Fed's decision, which was largely in line with my expectations, and the subsequent reaction, I believe that Mr. Market is telling us through the charts to expect an economic downturn. First of all, you have the long Treasury bonds, which rallied to all-time highs partly on the news of the FOMC statement indicating that they would be undertaking Operation Twist.

Remember, bond bullish = equity bearish
Dr. Copper has also decisively broken support, which indicates further economic weakness:

To underscore the scope of the commodity slowdown, Rio Tinto CEO said in an interview with the FT that customers are delaying deliveries:

“It is noticeable that markets are somewhat weaker,” said Rio Tinto chief executive Tom Albanese in an interview. “In a few cases, customers are asking to reschedule deliveries. “This is consistent with customers being cautious about the current state of business.”

Currencies of commodity sensitive countries such as Canada are breaking down technically. The Loonie fell through par against the US Dollar, which also signal global weakness. The next logical stop is 95c.

More worrying is the relative performance of the US banks against the market. This sector continues to weaken on a relative basis, which indicates further deterioration and rising systemic risk in the financial system.

The fact that American bank stocks are significantly underperforming is a source of serious concern as the source of financial stress comes mainly from the eurozone. We are already seeing signs of an institutional bank run in Europe. Siemens pulled money away from SocGen, Lloyd's of London has pulled deposits from some banks of peripheral countries and the Chinese have halted FX swap with selected European banks. The European banking system is extremely fragile. If any major bank loses its short-term funding for more than a few days we could see another Credit Anstalt meltdown on our hands.

Given all these negatives, can we expect the S+P 500 to hold support at the 1120 level?

All this market action is screaming, "Risk off!"

My inner investor is staying with the long Treasury bond trade, largely because the Asset Inflation-Deflation Timer Model has been singaling deflation for several weeks. My inner trader tells me that the long bond is tactically overbought and to wait for a pullback before getting long.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Don't expect miracles from the Fed

Many years ago and in a simpler time, we believed in Santa Claus and the Easter Bunny, also that Dad would fix things when he got home.

Today, we believe in the FOMC.

In anticipation of the results of the two-day FOMC meeting, let's review what the likely actions the Fed are going to take:

1. Operation Twist: Extend the maturity of the Fed balance sheet buy selling short-term Treasury paper to buy longer-dated ones.
2. Reduce or eliminate the interest paid on interest on excess reserves (IOER) in order to encourage banks to lend.
3. A better and more transparent communication strategy in order to better explain Fed objectives and intentions.

All these actions were signaled in advance in the WSJ's Fedwire:

Fed officials are likely to consider other steps they might take to boost the ailing economy in the short-run when they meet Tuesday and Wednesday, including altering the composition of the Fed’s portfolio of securities so that it holds more long-term debt. The idea would be to push down long-term interest rates to stimulate more investment and spending. They also could try to encourage lending by cutting the 0.25% interest rate currently paid to private banks when they park money at the central bank.

The better communication policy came in the second paragraph of the article (and these articles in Fedwire are undoubtedly part of that communications strategy):

Fed Chairman Ben Bernanke has asked Philadelphia Fed President Charles Plosser and Chicago Fed President Charles Evans, two intellectual adversaries, to work with Vice Chairwoman Janet Yellen on how the Fed can better explain its economic goals to the public. One issue high on the agenda: Detail what changes in unemployment and inflation it would take to make the central bank veer from its low interest-rate policy, according to people familiar with the matter.

What twists are there to Twist?
Let's explore each of these one by one. First of all, Operation Twist has been widely anticipated and would not be a surprise to the market. It is unclear what the net benefits are. In the last FOMC meeting, the Fed stated that it would keep rates low for another two years, which signaled to the banking system that it was ok to put on the carry trade of borrowing short and lending long. Don't worry about rates in the short end, they said. If the Fed were to sell short-dated Treasury paper in order to buy longer dated ones without expanding its balance sheet, it could hurt the banks that went long that carry trade based on the FOMC's signal.

Is that what the Fed wants?


A possible deflationary spiral?
The idea of cutting or eliminating interest rates on excess reserves appears to be a good idea on the surface, but as Izabella Kaminska of FT Alphaville explains, it could be disastrous because it can lead to negative interest rates because the current IOER 0.25% rate acts as a floor on rates:

Which means in effect a lower IOER would put more balance sheet pressure on banks (overload them with more reserves) and make it increasingly difficult to make competitively priced loans, meaning net interest income would come under pressure. The only solution would be to pass those costs along to customers through things like negative interest rates on certain deposits.

To think of it another way, it would introduce a cost on money.

Which of course is possibly what the Fed wants to do to encourage the money to flow into the real economy — but it also runs the risk of kicking off a deflationary spiral that will be impossible to stop, especially if market expectations catch up with Fed thinking as regards deflation risks.

Would that have the perverse effect of driving people towards holding physical currency instead? Or a deflationary spiral?

In addition, Jerome Schneider of PIMCO believes that a cut IOER could boomerang and wind up hurting the banks and GSEs:

Schneider, who is head of the short-term and funding desk at Pimco in Newport Beach, California, notes that the GSEs are a main market participant in the fed funds market. He believes they may choose to park cash earning zero interest at the central bank rather than earning a few basis points by taking “incremental risks” in the markets.


“The result could lead to changing liquidity dynamics in [the] fed funds [market] and may eventually even push up fed funds rates,” said Schneider in an interview Tuesday. Pimco is one of the world’s biggest asset management firms with over $1.3 trillion in assets.

For banks, a cut on the IOER will likely put additional pressure on earnings margins as the spread between the cost of deposits and borrowing funds with reinvestment opportunities, including IOER, will be compressed. Additionally, domestic depository banks have to contend with additional fees charged by the Federal Deposit Insurance Corp. to insure deposits in their pursuit of income.

Unlike banks, the GSEs aren’t eligible to tap the central bank’s interest-paying excess reserve policy, so they have used the fed funds market to lend out idle cash.

Are those the risks that the FOMC wants to take?

I operate on the basis that the Federal Reserve is not just one person but an institution, with economists on staff. Many of the former staff members, as well as former governors, have gone on to careers on Wall Street and I have met a number of them. Most of them are smart and aware of these technical issues relating to the effects of such proposed changes and their effects on the banking system. Surely the members of the Committee will be aware of these issues if they spent were two days considering their options.


What can the Fed do?
If eliminating IOER is off the table, then what's left? Operation Twist (meh) and a better (gasp) communication strategy?

The market would likely be disappointed with those two steps.

There is the off chance that David Rosenberg is right and Bernanke goes nuclear with the option of buying foreign securities as he stated in his famous helicopter speech [emphasis added]:

The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.

The USD swap lines established with the ECB can be a backdoor way of flooding Europe with USD liquidity. Expanding the swap lines does expand the Fed balance sheet. He already has significant political opposition to the expansion of the Fed balance sheet. To expand in order to rescue Europe might be one political bridge too far. Even if Bernanke had the votes to go down that road, it would risk a rupture within the FOMC, serious damage to his own credibility and the credibility of the institution of the Federal Reserve. In all likelihood, any course outside the three already telegraphed is a low probability event.

In short, I believe that anyone who thinks that the FOMC announcement will be a huge positive surprise to the market is akin to believing in Santa Claus. While Christmas does come once a year, but don't count on Santa bringing you all the presents you asked for.
 
 
 
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
 
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Encouraging action for bond bulls

Back on August 29, I wrote that it was not too late to buy the long bond and I remain relatively comfortable with that position, despite the likely volatility from the FOMC meeting this week.

For several weeks, traders have been frustrated as stocks and bonds appear to be stuck in a volatile news-driven range bound market.

While that may be true of stocks, the long bond yield fell to 3.19T yesterday, which is good news for bond bulls. The chart below shows the yield on 30-year Treasury, which is in a downtrend and staged a minor and unconfirmed downside breakout (upside price breakout).

While I recognize that the bond market rally may be in anticipation of the implementation of Operation Twist, this market action is nevertheless constructive for bond bulls. In addition, Maryann Bartels of BoA/Merrill Lynch reported that large speculators, which are mostly hedge funds, have a roughly neutral position in the T-Bond futures contract - indicating that the hedge fund/fast money doesn't seem to be positioned in anticipation of Operation Twist:

(Note that this data is a little dated from last Tuesday, September 13.) What's more surprising is that large speculators were near a crowded short in the 10-year note:

Bartels also reported that global macro hedge funds were net short the 10-year note, which is another indication that macro hedge funds are not frontrunning Operation Twist.

As well, Arthur Hill of stockcharts.com pointed out that industrial metals broke down through a technical support level yesterday, which is a signal of economic weakness - and another positive sign for bond prices.

Looking ahead to the FOMC meeting

While I am acutely aware of the event risk on Wednesday from the FOMC meeting, I agree with the analysis of Tim Duy. Underlying his assumption is the Federal Reserve is an institution of economists, who are mostly academically inclined, and not just one person. While Chairman Bernanke's opinions no doubt carry a lot of sway, he is not king.

I believe that the most likely outcome is some form of extension of the average maturity of the Fed balance sheet, along with an improved communication policy from the Fed in order to makes its decisions more transparent.
 
 
 
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
 
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The game of chicken begins

In this Greek crisis, the struggle is over money. Who pays the most?

Both the Germans and the Greeks know this. The Germans (mainly) hold the purse strings, but they don't hold all the cards. They may push the Greek government into austerity programs in order to extract greater savings and fewer euros in the rescue package, but the Greeks also know that they can cause the eurozone to collapse.

So they play a game of chicken.

It is therefore with interest that in the latest round, Greek Finance Minister Evangelos Venizelos took the unusual step of released a statement about the conference call with the Troika which by describing Greece as being "blackmailed and humiliated" [emphasis added]:

If we want to stabilize the situation, avoid default, always be within the Euro Area’s hard core, have the country stop being blackmailed and humiliated –because no Greek citizen must tolerate the country’s humiliation- then we have to make three grand strategic choices which constitute our national strategy:

[blah, blah, blah...]


This is a situation that leads to nowhere. The governmental committee formulated today a clear framework which will guide me tomorrow during my teleconference call with the representatives of the Troika, the European Commission, the International Monetary Fund and the European Central Bank, aiming at coming to an agreement on the fact that we need to meet our fiscal targets for 2011, to formulate a 2012 State Budget that leads to primary surpluses and to show that we have made progress and that we will take even faster and more determined steps in the field of structural changes like those announced by the Cabinet in its September 6 session.

At the about same time, Prime Minister Papandreou floated the trial balloon about holding a referendum about whether Greece should stay in the euro [emphasis added]:

As pressure from Greece’s foreign creditors and austerity-weary citizens mounts on the government, Prime Minister George Papandreou is considering calling for a referendum on whether Greece should continue to tackle its debt crisis within the eurozone or by exiting the single currency.

According to sources, Papandreou hopes that the outcome of such a vote would constitute a fresh mandate for his Socialist government to continue with an austerity drive backed by Greece’s international lenders -- the European Commission, the European Central Bank and the International Monetary Fund.

A bill submitted in Parliament, paving the way for a referendum to be carried out, is to be discussed in coming days.

The Greeks are playing "chicken". If the situation wasn't so serious it would be amusing.


Addendum: I see that the Greeks have denied the rumors of a referendum, but isn't this the kind of trial balloon that you would want to float if you were to play chicken?


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Fed decision Wednesday a sideshow to Europe

What to make of last week? The events were certainly tumultuous and the fireworks haven't ended.

Let's start with Europe. First, we saw coordinated central bank intervention by providing USD liquidity to European banks. As Alistair Osborne of the Telegraph points out, central banks do not take this kind of action unless something is up.

Central banks don’t do that sort of thing unless something is up; and something is most certainly up. In the eurozone, an unfolding Greek tragedy is careering towards its final, brutal act. And, in our joined-up, global economy that spells trouble everywhere, with the odds shortening by the day on a return to recession.
 
So, are the central banks signalling Credit Crunch Mk 2 and a rerun of all those hilarious jokes (What’s the difference between an investment banker and a large pizza? A pizza can feed a family of four)? Well, yes and no. They could be signalling something worse.

This is a sign of something very, very bad on the horizon. How bad? A recent poll of economists put the odds of a eurozone breakup at 50%.

An even worse sign is how the stock market shrugged off the effects of this coordinated central bank intervention. The chart below shows the price action of the bank sector against the market. One day after the news of the big intervention, banks stocks underperformed the market. Contrast that to the price action of the sector when Warren Buffett came in and bought into Bank of America.

 
Over to you, sovereigns!
Central bankers appear to recognize that the world is again teetering at the edge of a cliff. They are trying to get ahead of the curve by taking action, but there are constraints on what the Fed, the ECB and other central bankers can do. Central bankers can provide liquidity to the banks, but they cannot provide solvency to the system. (See my discussion here on the difference between banking liquidity and solvency.)
 
 
Can Europe hang together?
The meeting of eurozone finance ministers in Wroclaw, Poland was a sign of how dysfunctional the EU has become and how the EU has lost all political cohesion. Where to start? Consider this summary of the meeting from the BBC.
 
Tim Geithner lectured the EU ministers the importance of political cohesion. "Either you hang together or hang separately", he told them. What was the response? The ministers told him to butt out of European affairs. So, forget about any prospect of Euro-TALF.
 
What about the Greek collateral issue? They can't even say the same thing at the same press conference! Olli Rehn, the EU Commission for Economy Policy stated, "Concerning collateral I refer to what Jean-Claude Juncker said previously. We are in progress and I trust we can soon get this issue out of the agenda."

Evidently Finland's minister Jutta Urpilainen hadn't read the same briefing memo: "Unfortunately I don't see that we can find a solution tonight."
 
German Finance Minister Wolfgang Schäuble went on to put the kibosh on the prospect of Euro-bonds: "It is completely clear that we must solve our problems on the basis of existing treaties. Treaty changes take time."

Olli Rehn was more diplomatic, but is this the European version of the Japanese answer of "we will give the matter the greatest of consideration"?

The first step will be a feasibility study with the Commission in the course of this autumn. In this study we will assess alternatives for euro bonds and we will dig deep into the economic and legal issues connected to the possible introduction of euro bonds.

For me a necessary condition of any possible introduction of euro bonds is a further reinforcement of economic governance in Europe, implying sustainability of public finances and sustainability of economic growth models in Europe.

Otherwise euro bonds will turn into junk bonds and that will not benefit anybody.

The story gets from bad to worse. At about the same time, the news came out that:

• Greece is backsliding on its austerity commitments.
• Portugal has under-reported its debt to the tune of 0.3% of GDP, or more.

So what do the eurozone ministers decide? They agreed to delay the decision to give next round of aid to Greece approved to early October. The aid, if approved, would be for disbursement in mid-October and conditional on Greece meeting its targets. This puts an incredible amount of pressure on the Greek government to comply with even more draconian measures of austerity.

All European politicians are caught in a bind because they need to make highly unpopular decisions. For the Greeks, further austerity can only lead to more political unrest. This study shows that budget cutbacks of more than 5% of GDP greatly heightens the risk of protests, general strikes, assassinations and chaos. At the extreme, it can lead to revolution. The Polish finance minister warned last week that a eurozone collapse could lead to war.
 
On the electoral front, Denmark recently elected a new government that campaigned on a platform of tax increases and increased public spending - which is contrary to the wave of austerity sweeping Europe. The bailout of the Club Med countries is incredibly unpopular in Germany and Angela Merkel must be aware of that as her party recently suffered an electoral defeat in her home state and got crushed in another one in Berlin over the weekend.
 
 
The end game for Europe
These events scream the loss of European political cohesion. Everyone out for themselves. Don't expect the EU to come together with a sensible package that gets them out of this mess without a crisis. That leaves the following possibilities:

1. Greece takes one "for the side" by implementing the austerity package and stays in the euro.
2. Greece defaults and leaves the euro.
3. The EU engineers an orderly default for Greece. On the weekend, eurozone finance ministers agreed that European banks need recapitalization, which is a constructive first step.
4. The EU tries to muddle through with a series of aid packages for Greece in order to kick the can down the road, knowing that it will lead to eventual default (see 2).
5. The EU countries all agree cede power to a greater centralized authority. Such a change will require constitutional change by all member states.

By the way, don't expect China or other BRIC countries to come to the rescue. Patrick Chovanec has a good commentary here on why China is unlikely to be the savior. Don't forget China's mercantilist tendencies. Any Chinese investment into the eurozone may be just their way of stabilizing the EURCNY exchange rate.
 
Peter Boone and Simon Johnson summarized the European dilemma well here. They concluded that there are no good ways out [emphasis added]:

Expect a great deal of shouting behind the scenes at the highest level in Frankfurt (ECB headquarters) and in European capitals. Instability seems unavoidable. Significant inflation may also follow – although first we will see serious recessions in the troubled European periphery, a ratcheting up of bond buying, and repeated political crises.

The US cavalry to the rescue?
Can the United States be the savior of Europe? Earlier in the week, there was some speculation that Tim Geithner might present some ray of hope to the Europeans with funds, instead of just suggestions on how they might fix their problem. Alas, no money is forthcoming. There is simply no appetite on the fiscal side for any stimulus, even for the US economy.
 
The Fed is the wildcard.
 
Doug Short reported that the latest release of the ECRI Weekly Leading Index shows it plunging again and ECRI head Lakshman Achuthan stated on NPR that there is a high risk of another recession. This would give the Bernanke Fed cover to act decisively.
 

 
ZeroHedge reported that even uber-bear David Rosenberg is expecting Fed action on Wednesday beyond Operation Twist. In last Friday's edition of Breakfast with Dave, he wrote that Bernanke watches stock prices as a measure of the effectiveness of Fed policy:

Even the casual observer can have no doubt, then, that FOMC decisions move asset prices, including equity prices. Estimating the size and duration of these effects, however, is not so straightforward. Because traders in equity markets, as in most other financial markets, are generally highly informed and sophisticated. any policy decision that is largely anticipated will already be factored into stock prices and will elicit little reaction when announced. To measure the effects of monetary policy changes on the stock market, then, we need to have a measure of the portion of a given change in monetary policy that the market had not already anticipated before the FOMC's formal announcement [emphasis added].

Rosenberg believes that Bernanke is more likely to act now rather than later, because "the more he does now means the less he has to do later during the election campaign" and "he has the support from enough FOMC votes, including regional bank chiefs like Evans from Chicago, to be aggressive". He concluded that Bernanke needs to give the stock market a positive surprise on Wednesday:

[I]f Bernanke wants to juice the stock market, then he must do something to surprise the market. 'Operation Twist' is already baked in, which means he has to do that and a lot more to generate the positive surprise he clearly desires (this is exactly what he did on August 9th with the mid-2013 on- hold commitment). It seems that Bernanke, if he wants the market to rally, is going to have to come out with a surprise next Wednesday. If he doesn't, then expect a big selloff.

What kind of surprise? On Thursday, Rosenberg speculated about extreme measures available to the Fed by pointing to Bernanke's famous helicopter speech of November 21, 2002 [emphasis added]:

The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.

I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar.

Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly.

Given that the Fed participated in coordinated intervention last week, Bernanke must be worried. Indeed, the WSJ reported that the US financial system is highly exposed to Europe [emphasis added]:

If there is any doubt on this score, all one need do is consider the U.S. financial system's massive exposure to the European banks. In a recent survey, Fitch found that, as of the end of July, the U.S. money-market industry still had direct exposure to European banks of over a trillion dollars—or roughly 45% of money markets' overall assets. The Bank for International Settlement reports that American banks have loan exposure to German and French banks of more than $1.2 trillion.

Of course, all this moves are highly speculative. Even if any announced measure is likely to have limited effect, equity markets are likely to rally on the news of a positive surprise.
 

The week ahead
Here's what I am watching for for the week to come:
 
Monday: The Budget Committee in Germany's Lower House of Parliament will debate the EFSF expansion and Greek bailout. Watch for what comes out of those discussions.

As well, Greece updates the Troika (EU, ECB and IMF) on the progress of the implementation of the austerity package by conference call. The Troika has decided on not going to Athens. If the aid is not forthcoming, then the Greeks will run out of money around October 10. As I write this, the Greek cabinet is reportedly holding weekend emergency meetings in order to ensure that its budget in compliance with the Troika criteria. The EURUSD exchange rate is down about a penny and ES futures are deeply in the red.
 
Tuesday: Greece has bond payments totaling €769 million due.

Wednesday: The FOMC will announce its decision after an extended two-day meeting.

Get ready for the fireworks. My inner trader is wincing at the prospect of volatility of more up and down 2% days. My inner investor tells me that anything that the Fed does is likely to be a sideshow. If the Fed were to announce an unexpected round of stimulus, the markets may rally, but the final resolution will depend on how the European sovereign crisis is resolved.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.