Friday, November 18, 2011

Angela's choice

OK. Not only have Spanish and Italian bond yields have blown out against Bunds, now French yields are blowing out and there are suggestions that even Bunds are losing their safe haven status. The contagion has moved from the periphery to the core of the eurozone. The whole eurozone is unraveling as disunity is the story of the day, as an example consider the Bloomberg report Irish Government Draws Fire as Budget Plans Shown to Lawmakers in Germany.

In the past, we would have seen some market soothing statements from Merkozy by now, but the French and Germans are at odds and we therefore have no statement.

Now what?

What does Germany really think?
There is a consensus that the ECB has to act now and buy the sovereign debt of the troubled peripheral countries to stabilize the markets and buy some time for the eurozone governments to work out a solution their long-term imbalances. Hardliners in Germany, led by the likes of Jens Weidmann of the Bundesbank, have been adamant against such a move.

The question is, what does Angela Merkel do? Merkel has been all over the map on this issue. She has shown herself to be staunchly European and does not want the eurozone to break up. On the other hand, the revelation that Germany and France were conducting informal talks about a two-speed eurozone does not make her sound very European at all. In addition, the current government position that the the ECB cannot be the lender of last resort and the EFSF must not be given a banking license so that it could be supported by the ECB appears to be designed to push the eurozone over the precipice.

I believe the way to interpret her actions is that she is a skillful politician who has to walk a fine line between the competing imperatives of appeasing German sensibilities and the Realpolitik realities of the eurozone. Consider this account of German attitudes towards the euroozone [emphasis added]:
The nature of these meetings is that the hallway chatter is always more interesting that the formal program. Part of the reason why is that, particularly when talking to journalists, the businesspeople or politicians tend to regard those conversations as off the record. So I'll abide by that here. One of the German execs was a consultant, and the other headed what I'll call a quasi-official German organization.
They were slightly irritated by the pessimism I'd expressed earlier in the day. "Don't you realize," one of them said, "that the cost to us (Germany) of bailing out Greece is far less than it cost us to reintegrate East Germany after the wall came down in 1989?"
I almost choked on my croissant. Yes, I replied, I am aware of that. I lived and worked in Berlin as a journalist in the mid 1990s, when that very painful (economically speaking) process was taking place in Germany. But doesn't that, I said politely, rather beg the question: Germany integrating their brethren, who'd been isolated and impoverished during the cold war, was a dream come true, whatever the cost. Germans, on the other hand paying to bail out Greece is, to average German, rather the opposite of a dream come true, is it not?
He waved me off. No no, he said, it will be taken care of. The Germans, he said, understood how beneficial to them membership in the euro zone has been. Without it, the gentleman said, the value of the Deutschemark would be 50% or 75% higher than it is under the euro. "German industry would be wiped off the map."
In other words, the Germans understood the benefits of the eurozone and loathed to give it up, but they wanted the periphery to take the pain of adjustment:
Now the consultant perked up, speaking what he too believes to be the unvarnished truth. They have to, he said, because "to be blunt about it, we have them [both the Greeks and the Italians] by the balls."

And make no mistake – that, in essence, is where the European crisis stands. The Germans -- and the ECB along with them -- believe (perhaps hope is the better word) that two new technocratic prime ministers, former EU commissioner Mario Monti in Italy and MIT-trained economist Lucas Papademos in Greece, will cast politics aside and force angry populations in both countries to take their medicine, whether they like it or not. Because it's for their own good, you understand. And besides, "we have them by the balls. They have to do what we say."

Germany is at risk of overplaying its hand
I believe that Merkel is well tapped into this German attitude, but she has stared into the abyss and realizes that Germany is at risk of overplaying its hand in pursuit of the goal of greater fiscal integration. As Tim Duy correctly points out, Merkel & Company is playing a very dangerous game of chicken and the whole edifice could come tumbling down should anyone make the wrong move.

She is therefore trying to soothe German attitudes (I am on your side) but at the same time steer the German public consciousness toward the view that maybe Germany doesn't quite have Greece/Portugal/Italy/Ireland by the balls.

To do that, Merkel will have to manufacture a crisis. The brinkmanship and all the hawkish statements coming out from Germany that we see today may be just for public consumption. This is all theatre to show that we are indeed headed for a crisis, so they have to take extraordinary measures to save Europe.

Don't forget, Merkel has shown herself to be very European in outlook. Consider, for example, her statements ahead of a CDU party congress which has tabled a proposal for countries to leave the eurozone:
“For months, since the very beginning of the Euro debt crisis, Germany has had only one goal, that is to bring about a stabilization of the Euro zone in its current form, to make it more competitive, to consolidate budgets,” Merkel told a news conference after talks with Romanian President Traian Basescu.

“And we firmly believe that this common Euro area is capable of winning back full credibility, including every single country.”
Moreover, this report from the FT shows that the CDU leadership is nudging its membership towards greater flexibility in allowing the ECB to take action:
At party conference this week in Leipzig, Ms Merkel’s Christian Democratic Union left room for manoeuvre, however. Bond purchases by the ECB were acceptable as a “last resort,” the party agreed in a resolution at its annual conference. The ECB may yet get to show what it can do.
At the about same time, the German Council of Economic Experts, or the "Five Wise Men", has drawn up a plan for a European Redemption Fund at sounds a lot like a eurobond with strings attached. The idea of eurobonds has been anathema to the German public and the German government. The "five wise men" is a council of economists nominated by the government to advise on government policy. Could such proposals be a way of floating a trial balloon while allowing Merkel's government to distance itself should political opposition become fierce?

Another clue that that Merkel is preparing the groundwork for a rescue of the periphery countries comes from this story of an interview of Jörg Asmussen, the incoming chief economist for the ECB. While he echoed the official German government line, some of his responses were nuanced [emphasis added]:
Mr Asmussen would not be drawn: “If you speculate about plan B, then plan A is kaput.” Plan A rests on five factors, all of which have to be in place, he said: a plan for debt resolution and growth for Greece; the prevention of contagion to Spain and Italy; creating a firewall by getting banks to mark down their holdings of government bonds and add more capital; building another firewall with the EFSF; and, finally, setting a road-map for deeper monetary union.
Nobody really expected Mr Asmussen to discuss plan B. Nor was he likely to reveal his innermost thoughts. But so cleverly did he speak that there will be no loss of face one day when the government rolls out plan B.
Given that the crisis is already here, the question of a rescue is one of timing.

A matter of timing
Already there are rumors circulating about a plan for the ECB to lend to the IMF, which then lends to the troubled peripheral countries. The stars appear to be lining up for such a move. The plan makes sense as the IMF has the resources to monitor individual countries for adherence to austerity programs while the ECB does not. Such a move also provides a fig leaf for the German government to appease the hardliners as this plan does not appear to violate any treaty terms.

At the same time that European bond yield spreads are blowing out, technicians over on this side of the Atlantic are sounding warnings about the bearish implications of a downside penetration of a triangle on the SPX on Thursday:

I would warn the bears that this has the markings of a possible fake-out. The index is now resting at its 50% Fibonacci retracement level and I would suggest, even if you are bearish, wait for a reflex rally to get short.

The conundrum for traders is a question of timing. Does Merkel have the political capital to put such a plan in place now? Or does she have to allow the crisis to continue in order to scare the living daylights out of everybody in order to say "we had no choice but to act"?

If she chooses the latter route, events could spiral out of control (even on this side of the Atlantic). As an example, Bruce Krasting painted a nightmare scenario stemming from the failure of MF Global because of the inability of anyone to find the missing $600 million in segregated funds [emphasis added]:
Give the MFG story another month and it will be a problem. It will undermine markets. It will impact confidence in our financial system. It will impact liquidity. As those things occur it will force both Treasury and the Fed to take actions. While those actions may not take the form of any direct bailout of MFG and/or its customers there will be a significant cost to the broader economy.

In an environment of uncertainty, how do you know your money is safe in any account? Krasing believes that the MFG failure could lead to a crisis of confidence and liquidity seizing up in the financial system
I have no doubt that money in seg. accounts at the likes of Merrill and Morgan Stanley is safe. That does not matter. The cheapest thing one could do is put cash outside of seg. accounts. The most expensive thing one could do is leave it there and face a loss of principal. It’s a very lopsided risk and reward.
Weekends seem to be a good time for the authorities to act and there are wheels within wheels with the politics of this eurozone crisis and traders should just react to headlines. Don't ever forget why the EU came together in the first place and how committed the elite to this marriage.

At the very least, bearish traders may want to wait until Monday before putting on short positions.

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.

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