Two-track eurozone: wheels within wheels

I take my assertion in my last post about a possible Merkel capitulation back. The Reuters story about the Franco-German discussions about a eurozone breakup, or a two-speed eurozone, was ex[;psive on a day when Italian yields spiked, but a further Reuters story indicates that the "informal" discussions had been going on for a month. Moreover, the discussions were at a theoretical level and not centred on the nuts-and-bolts of how it would be done:

The change has been discussed on an "intellectual" level but had not moved to operational or technical discussions, the EU official said. A French finance ministry spokesman denied there was any project in the works to reduce the currency bloc's membership .

More interestingly were the affirmations of this highly risky approach from both Paris and Berlin.

French President Nicolas Sarkozy gave some flavor of his thinking during an address to students in the eastern French city of Strasbourg on Tuesday, when he said a two-speed Europe -- the euro zone moving ahead more rapidly than all 27 countries in the EU -- was the only model for the future.

And:

Speaking in Berlin, Merkel reiterated a call for changes to be made to the EU treaty -- the laws which govern the European Union -- saying the situation was now so unpleasant that a rapid breakthrough was needed.

From Germany's point of view, altering the EU treaty would be an opportunity to reinforce euro zone integration and could potentially open a window to make the mooted changes to its make-up.

Who is trying to do what to whom?
So here is the question: If discussions had been going on for a month, why did the story break yesterday of all days, when the financial markets were in turmoil? This was probably a leak. It sounded like too orchestrated to me. It seemed to me that it was done for maximum impact.

If that was a leak, then who did it and why? I have several theories:

1. Angela Merkel has come to the realization that only the ECB can save the euro. She had the story leaked to throw panic into the markets to pressure the German hardliners within her government and the Bundesbank. In that way, it would give her political cover to give Mario Draghi the nod to start monetizing debt.
2. The French want the ECB to act. They had the story leaked to throw panic into the markets to pressure the German hardliners within the German government and the Bundesbank.
3. Mario Draghi and the ECB wants Silvio Berlusconi out sooner rather than later. This was leaked to throw gasoline on the fire.
4. Ambrose Evans-Pritchard wrote:

Veteran EU watchers say the leaks appear to be a heavy-handed attempt from certain quarters in Berlin to force austerity compliance in southern Europe.

Personally, I think that either 1 or 4 are the most likely possibilities. In typical European fashion, there seems to be a lot going on behind the scenes with different factions of the elite jockeying for position. The good thing is that the Germans are actually having a hard internal debate of what they want out of the EU and the eurozone.

So I take it back. This was not a Merkel capitulation and panic moment. But don't just watch and react to the headlines, there are wheels within wheels as pawns are maneuvered around the European chessboard.



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.  

Is this the Merkel capitulation?

Is this a sign of panic from Angela Merkel? As we watched markets crater over the spectacle of an Italian bond market melt down, Angela Merkel seems to have thrown in the towel and called for a breakup of the eurozone. Reuters reports that she agreed with Sarkozy's idea of "a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stays more loosely connected "

It is time for a breakthrough to a new Europe. A community that says, regardless of what happens in the rest of the world, that it can never again change its ground rules, that community simply can't survive.

The Guardian confirmed the story by reporting that Germany and France have begun talks to break up the eurozone amid fears that Italy will be too big to rescue. Bloomberg also reported that Merkel’s CDU may adopt Euro exit clause in party platform. Interestingly, the story showed Mario Draghi to be very European in outlook:

Mario Draghi, in his first week as European Central Bank president, said Nov. 3 that it’s not illegitimate to question Greece’s place in the euro area. Even so, the bloc’s founding treaty doesn’t allow for a country leaving and it would be hard to imagine it happening, he said.

Is this talk of a eurozone breakup signs of panic and capitulation from Angela Merkel? Is this a buy signal or a sign that Europe's Lehman moment is upon us?


Implications of a eurozone breakup
The implications of a eurozone breakup are profound. Despite the rhetoric, Germany has benefitted tremendously from membership in the eurozone. Credit Writedowns wrote that, since Germany runs a huge trade surplus with the rest of the eurozone, German-Southern Europe trade has become a giant vendor financing scheme.

The large euro-area internal current account imbalances should be seen as a form of vendor financing, whereby the creditors, principally Germany, forward their customers, the debtors, trade finance in order to sell their wares. Germany’s aging society meant slow growth. So German companies have looked abroad for growth, just as the Japanese have done in their aging society. Taken in aggregate, this means persistent current account surpluses which are a fancy way of saying vendor financing at the national level.

German banks were at it too, by the way. German retail banking is a low margin business and credit growth is weak. So the German banks loaded up on foreign assets, making loans abroad. German banks were very active in Ireland and Spain during the housing bubbles there, for example.

German industrial companies must know this. While the Teutonic holier-than-thou attitude may play well for public consumption, I can't believe that German exporters aren't making their views known to the government.

Even if Germany and France wanted to break up the euro. How do you get from A to B? How do you re-negotiate a treaty with 17 signatories? What do you do in the meantime? Do you sit around planning the nuances of how to revise EU treaties while watching global financial system disintegrate around you?


A green light for the ECB to go nuclear?
Remarks about "the new Europe" and the "two-speed Europe" sound either like signs of panic or carefully timed leaks. This may be a sign that Mario Draghi will be given the green light to go nuclear despite the deep reservations expressed by the likes of Juergen Stark.

Indeed, the ECB has not been idle but it has been expanding its balance sheet despite the rhetoric about treaty obligations, etc.

The latest report shows that it bought €9.5 billion in sovereign bonds. Nevertheless, its hands may be tied by treaty. Ambrose Evans-Pritchard writes that

Jens Weidmann, head of the Bundesbank and the ECB's dominant governor, said...Article 123 of the EU Treaty imposed a legal "prohibition on monetary financing", implying that the ECB cannot attempt to shore up the debt markets of Italy and Spain for covert fiscal support.

Therefore the ECB has a strict limit to how far it can go to buy sovereign bonds directly from Italy, as per Article 123.

Yet, where there is a will, there is a way. After all, don't forget that Germany went into the euro with roughly 90% of the population opposed to the move. OK, so if the ECB can't lend directly to a sovereign country, what can it do? Alan Beattie of the FT explains:

One intriguing idea floating around Washington: if the ECB can’t bring itself to bail out Italy direct (sovereign credit risk, no expertise in setting lending conditions) it could in theory, according to Article 23 of its protocol, lend vast amounts to the IMF.

The Fund would then lend them on to Italy, taking on the credit risk and enforcing conditions – both of which are what it is there for.

Panic is in the air
In the meantime, the world is in full-fledged panic mode. Ezra Klein's article entitled Is this how the euro ends is typical of the sense of terror gripping analysts. After all, Italy is a G7 country which borders two other G7 countries. Another, the UK, is in the same economic union. Will the eurocrats truly allow the European and global economy to go down in flames?

The problem, put simply, is that Italy is both too big to fail and too big to save. It’s the eighth-largest economy in the world. At $2 trillion, it’s about seven times as large as Greece’s $300 billion economy. France and Germany’s banks alone have $600 billion in exposure to Italian debt. But Barclay’s says Italy is “now mathematically beyond the point of no return.” Silvio Berlusconi might be out, but changing governments does not change arithmetic. And so the question is simple, and stark: If there wasn’t the will to really save Greece, where would the will -- and the money -- come from to save Italy?

Brad DeLong has gone even further and urged the Federal Reserve to intervene by calling up the ghost of Creditanstalt and 1931 [emphasis added]:

I have been complaining for some time now that Reinhart and Rogoff think that the time is always 1931 and that we are always Austria--that the great fiscal crisis is about to erupt and send us lurching down toward Great Depression II. Well, right now guess what? The time is 1931, and we are Austria. The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip. The Federal Reserve needs to do so now.

If Italy goes down and takes its G7 European partners down with it, then no one is safe.


What will Merkel do?
So the big question is now, "Is this Merkel's capitulation moment?" Does she really want to go down in history as the one who could have save the eurozone but didn't? Will Merkel, or some of the cooler heads around her, allow the ECB to go nuclear as a stopgap in order to save the EU?

A word of warning for traders. Those who wait for the ECB to act before the weekend may be disappointed. There is a theory that Draghi wants to force Berlusconi out now instead of later. So the ECB is standing aside and letting the markets do its work for them. If the markets go into freefall for the next couple of days, the weekend is the perfect time to do a deal - after which the markets would melt up in relief that the Apocalypse has been avoided.
 
But first things first. It's up to Angela Merkel to take the first step and show some adult leadership. Will she allow the ECB to take steps and save Europe (at least temporarily)? Or will this be Europe's Lehman moment?
 

Addendum: I take it all back. It wasn't a Merkel capitulation moment. See further details here.


 
 
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.

Is financial repression the next step for the eurozone?

I would like to explore the long-term options for the EU and the eurozone out of this crisis. Most observers have offered two options for Europe, but I would like to raise a third - of financial repression. The options, which I list from the least likely to most likely are:

• Exit from the eurozone: Greece and perhaps Portugal and other weaker economies of the eurozone exit the euro, either individually or as a group. This would be a disaster, not only for Europe but for the global economy and financial system.
• A fiscal union: When the euro experiment began, it was acknowledged that this was a monetary union without a political union. A fiscal union, in which individual member states give up some degree of sovereignty to a greater EU authority, is the next step towards a politcal union. Taking such a step requires constitutional change by all eurozone member states, which is a long and involved process and may not be successful in the end.
• Financial repression: If you read Reinhart and Rogoff, first comes the financial crisis, then the sovereign crisis. The next step is financial repression, where the authorities try to extract greater wealth from its citizenry. Given Europe's predilections towards muddle through solutions that kick the can down the road and its tolerance towards higher taxation, I believe that this is the most likely solution for Europe. Though such a path will impose a significant constraints on its engine of long-term economic growth.

Eurozone exit
I am getting  tired of writing about gloom and doom so I won't dwell on this option too much. I wrote about it before here and extensively elsewhere. The worst case scenario is the Argentina one, as described by John Hempton of Bronte Capital:

When Argentina defaulted not only did the government default but they forced a private default. If you had a debt in US Dollars in Argentina prior to the default you were forced to pay it back in Peso. Indeed it was illegal to make payment in US dollars.

Likewise if you had a US dollar asset you got back Peso. A dollar deposit in Citigroup in Buenos Aires became a peso deposit. If you really wanted to keep your dollars you needed to make your Citigroup deposit in New York.

The forced private sector default was necessary for Argentina. The Argentine banks all had lots of US dollar funding. If you devalued without forcing their default then they would all have uncontrolled defaults (a true disaster) and the country would lose its institutions. Telefonica Argentina would have failed too - failing to replay USD debts.

The same applies in Greece. If the Greek Government were to devalue the new Drachma (to perhaps a third the value of the Euro) then the banks (which are loaded with Greek Sovereign paper) would default. Even Hellenic Telecom would default because they would be forced to repay their billions of Euro borrowings whilst collecting only Drachma phone bills.

If Greece did that, it would mean the end of the eurozone banking system in the weaker countries:

Now if you are Irish or Italian or Portuguese (or even Spanish) you know the rules. You get to get your Euro out of the PIGS and into the core (Germany) as fast as possible. So max all your credit cards (for cash), draw all your bank deposits and load them in the boot of your car and make the drive to Switzerland or Germany. Somewhere safe. Otherwise you are going to lose half the value the day that the rest of the PIGS do a Greece.

And this bank run – a run including tens of thousands of Italians driving their Fiats - will surely blow apart every Italian bank. And their Euro-skeloritic compatriots will sign the death knell for for all their banks too.

You get the idea. Pulling an Argentina would create chaos in the financial markets.


Canada as a model for fiscal union
What about a fiscal union? A fiscal union would mean individual eurozone states ceding some form of taxation power to a central authority - sort of a "Brussels on the Rhine". What would a fiscal union look like? Well, it would sort of look like...Canada. Jeffrey Simpson, columnist for the Globe and Mail, explains:

The great virtue of real federalism is the sharing of risks, which is why Canada is a much sturdier federation than Europe. Canada’s central government raises far more revenue as a share of the national total than Europe’s central institutions, redistributes far more of it to less well-off regions, and takes a large share of borrowing.

In Europe, member-states must pay their entire debts; in Canada, provinces pay some of their debt, the whole country pays the rest. The difference means when highly indebted European economies falter or interest rates skyrocket, they face burdens that the European Central Bank and member-states try to ease with Band-Aid solutions.

In Canada, weaker provinces and/or highly indebted ones (Quebec and the four Atlantic provinces) don’t have to pay both their debts and their per capita share of the national debt. Ottawa pays the per capita share. The sharing of risk, opportunity, burdens and good fortune is what makes a federal system.

The European Union was never a federal structure like Canada. It worked best in sharing good fortune and some risk; it worked badly, as we now see, in sharing burdens because it lacks the central resources of a federal system.

The Canadian system is workable, but not perfect. We have seen our share of constitutional crises over the years and the Quebec sovereignty movement continues to lurk as a threat in the background. In Canada, the stronger provinces send money to the weaker ones in the form of equalization payments via Ottawa. This arrangement works because it isn't just welfare, but a form of counter-cyclical stabilizer. Simplistically speaking, Canada is economically divided between resource-based regions (which are mostly in the west) and the manufacturing heartland in southern Ontario and parts of Quebec. When resource prices are low, the manufacturing base booms; and when resource prices are high, manufacturing margins suffer. Equalization is a therefore a form of counter-cyclical stabilization for provincial economies and budgets.
 
In the eurozone, however, such counter-cyclical arguments fall flat. The perennially weak countries are not resource producers, nor does it appear that their economies are in any shape or form counter-cyclical to the industrial heartland. Consider how some of the more troublesome PIIGS countries achieved their recent success. Spain saw a property boom, which subsequently collapsed. Ireland became the Celtic Tiger because of its low corporate tax rate, which encouraged offshoring. Italy remains a world-class centre of manufacturing and design (think Ferrari and Gucci as examples) but suffers from competitive problems. While some of the PIIGS problems are cyclical, the root cause appear to be a lack of competitiveness that is usually solved by currency devaluation.
 
Such an arrangement leaves the industrial heartland permanently digging into their pockets to support their poorer cousins. The Germans get this concept quite clearly. German finance minister Wolfgang Schäuble has stated that Germany does not want to rule Europe (and by extension, be permanently on the hook for support payments).

For the recipient of EU largesse, the consequences of giving up fiscal sovereignty to a "Brussels on the Rhine" can have governance effects that appear to be heavy-handed. It may feel like your country is under occupation. Ambrose Evans-Pritchard of the Telegraph wrote about this problem when the EU presented Italy with an ultimatum [emphasis added]:

The EU has woven itself into this drama by presenting Italy with an ultimatum last week, giving the country barely 48 hours to commit to very specific and radical reforms.

It is in effect taking sides in an intensely polarized debate within Italy, intruding in the most sensitive matters of how society organizes itself. It is demanding ideological changes – in this case in favour of employers, and against unions – as a condition for further action to shore up Italy’s bond markets.

"We have three deaths in front of us: democracy, politics, and the Left," said Fausto Bertinotti, the elder statesman of Rifondazione Communista and one of Italy's great post-war figures.

"We are living in a neo-Bonapartist financial system. Not a single decision has been taken by the Italian parliament since the end of August except those imposed by the foreign power that now us under administration."

Those of us who live under an "Anglo-Saxon economy" may not find it odd that we demand our partners to end the labor friendly practices that seem outrageous to us in return for financial support, but Evans-Pritchard wrote that, in a democracy, you have to get the populace to make the decision freely:

The two bones of contention are Article 18 protecting workers from being sacked for economic reasons, and “firm level agreements” that undercut the power of trade unions to craft deals across sectors.

Those of us in Anglo-Saxon cultures may find it remarkable that Italy still has laws that make it extremely hard for companies to lay off workers when needed. It is clearly a reason why the country has struggled to adapt to the challenge of China, rising Asia, and Eastern Europe.

But that is not the point.

Are such changes to be decided by Italy’s elected parliament by proper process, or be pushed through by foreign dictate when the country is on its knees? “Political ownership” is of critical importance. The EU is crossing lines everywhere, forgetting that it remains no more than a treaty organization of sovereign states. Democratic accountability is breaking down.

Today, we have Troika monitors in Greece and IMF monitors in Italy. How far will it go before the people of the peripheral countries feel like they are under occupation? Jim O'Neill of Goldman Sachs Asset Management has stated that he believes that a number of countries, ranging from Greece to Finland, would rather pull out of the euro than live under the rule of a Brussells on the Rhine.
 
 
Financial repression
The most logical solution, given a willing populace, is then financial repression. Governments practice forms of financial repression all the time. CLSA's Russell Napier lays it all out:

So far, only a small section of the private sector has been forced to pay up for the follies of the public - the depositors whose saving are being destroyed by negative real interest rates and those on fixed incomes they can't force up to meet inflation. But the extension of this theft is likely to mean forcing institutions to buy government debt on previously unimagined scales. In India, the banks have a standard liquidity ratio of 25%, the explicit aim of which is to “augment the investment of the banks in Government securities.” Why not Italian banks too? And why not the pension funds?

The template was laid out by Carmen Reinhart and Ken Rogoff:

If you want to see how all this unfolds you should simply read - or re-read - what appears to be the best road map of the crisis so far, Reinhart and Rogoff’s This Time is Different or the paper Reinhart co-wrote this year titled The Liquidation of Government Debt. As they say “first comes financial crisis; then comes sovereign debt crisis; then comes financial repression.”

Already, such proposals are being floated. FT Alphaville wrote last week that while the Italian government is in debt, Italian households are remarkably debt free and have an abundance of liquid assets:

[There is] €8,600bn of household wealth vs. the €1,900bn public debt mountain. Around 50 per cent of Italian government bonds are already in domestic hands, according to Credit Suisse, but there still could some firepower left, in theory, thanks to the country’s decent stock of financial assets at a tidy €3,565bn, according to the Italian central bank.

The solution sounds a lot like financial repression to me:

Here’s one thought experiment floated by Tullio Jappelli, economics professor at the University of Naples Federico II, who told us via email that if the government decided to launch a raid on savings it could:

…seize a part of our checking / saving accounts and convert this cash into bonds.

In 1992, under the Amatao Government there was a wealth tax, passed in 24 hours (0.6 percent of deposits were seized by the government). [The above] proposal is better from the consumers’ standpoint, because you convert cash into bonds, not into taxes. But you need to do it VERY quickly, otherwise you risk a bank run and deposits to disappear. All these things are dangerous objects, so please be careful with how you handle them..

Governments have long practiced this form of financial repression. As an example, pension funds under certain regimes have been mandated to hold a certain portion of their assets in government bonds for "prudent" reasons.

Given the alternatives, this solution is probably the least politically painful for the authorities and will kick the can down the road for a few years. So watch for financial repression - coming soon to your European neighbourhood.



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.

Market indecision

The behavior of some asset classes have been downright puzzling. I have been writing for several weeks about what a basket case the eurozone is. Despite the results of the Greek vote on the weekend, nothing is solved. The contagion is starting to spread to Italy, as 10 year Italy-Bund spreads are blowing out.

The EFSF, whose details are still not finalized, is starting to look more and more DOA. Here is Lisa Pollock of FT Alphaville discussing how many investment banks won't even touch making a market on EFSF CDS:

With the EFSF though, it’s all about self-referencing, which is another way to describe the wrong-way risk involved.

To have a quick and dirty example of that, think about whether you’d buy protection on France from BNP Paribas, or protection on the UK from RBS, or protection on Germany from Deutsche Bank. If the CDS spreads on any of those banks started widening out significantly, it’s safe to bet that their lender-of-last-resort sovereigns will start widening too. This is something we’ve seen happen a lot over the last few years. Similarly, one can see banks widening with their sovereigns, as their backstops look increasingly vulnerable.

If you did any of those trades, you’d be deeper in-the-money, but at the same time, your counterparty is starting to look increasingly fragile (and you’re probably having to hedge against the possibility that they might not be able to pay you too).

A deteriorating outlook
What's more, the forward looking indicators are in decline even though the backward looking indicators are appeaing relatively buoyant. Both the Fed and the ECB cited deteriorating outlooks last week in their statements. Here's the ECB:

The economic outlook continues to be subject to particularly high uncertainty and intensified downside risks. Some of these risks have been materialising, which makes a significant downward revision to forecasts and projections for average real GDP growth in 2012 very likely.

And here's what the Fed said:

Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.

Ed Yardeni observed the same phenomena when he analyzed 3Q Earnings Season [emphasis added]:

It has been a great earnings season. It’s not over yet, but of the 388 S+P 500 companies that have reported their Q3 results, earnings are up 22.9% on a 12.7% increase in revenues. The problem is that even as companies have provided lots of positive surprises, analysts have been cutting their earnings estimates for Q4 and all four quarters of 2012. That’s because they are turning increasingly cautious on the outlook for revenues and for the profit margin.

The WSJ also echoed a similar sentiment when it wrote that Earnings Warnings Ratio Highest in a Decade.


Some excellent questions
If Europe is such a mess and the economic outlook is tanking, then why isn't the US Dollar, which is undervalued using PPP measures (see examples here and here) and the traditional safe haven, rallying harder? Shown below is the point and figure chart of the USD, why isn't it at least in an uptrend?

You could argue that investors are avoiding the USD because of fears of currency debasement, which is a serious problem with fiat currencies in the current environment. In that case, pressures should be showing up in hard asset prices. Why aren't commodities in a well-defined uptrend?
 

Those are, as they say, excellent questions.
 
 
Beware of policy intervention
Despite the overwhelming macro risks that face the market, I believe that the reasons that the price of risky assets haven't totally fallen apart is because Mr. Market is discounting the possibility of policy intervention. Last week, the FOMC statement had a decided dovish tone. While they did not outright announce QE3, they did say that the outlook is decidedly weak. More importantly, the two more hawkish members of the FOMC fell into line and voted with the rest of the Committee. The only dissenter was a dove who wanted greater accommodation. In the post-meeting press conference, Bernanke did allow that the Fed would look at MBS purchases if the circumstances were right.
 
On the next day, the ECB surprised the markets with a quarter point rate cut. Mario Draghi appeared to be far more pragmatic than Jean-Claude Trichet, though just as European. He did appease the German wing of the ECB by stating that sovereign debt purchases were intended to be "temporary" - which was very European of him.
 
Larry Jeddeloh of TIS Group is accordance with my views about market anticipation of central bank intervention [emphasis added]:

The ECB Moves and The Bernank Places a Put Under the Market—In the past forty eight hours, several important changes have taken place in the global central banking community. When new ECB chief Mario Draghi unexpectedly cut interest rates even by 1/4 point on Thursday, he confirmed what I have been saying about Europe’s economic position. Continental Europe is in recession and the models I look at suggest all of the major European economies will see rapid decelerations in their economies. This is one of the reasons why Draghi did what new central bankers seldom do, cut interest rates on virtually his first day at the job.
 
One day before Draghi moved the ECB into easing mode, the Bernank held a press conference after the FOMC meeting. For the first time in a long time, the stock market actually went up, rather than down after he finished. What did he say that the market liked? I think he was absolutely clear that the Fed will be there, if needed, should the economy decelerate. He set the stage for QE3 by reducing the Fed’s forecast for the economy and he gave little comfort on the employment front. He set up a move to QE3 solely on the basis of the Fed’s mandate...
 
There is more evidence the markets/CB policy have reached an inflection point. In the emerging countries, Brazil’s central bank has cut interest rates twice. India appears to have stopped tightening. China is beginning to make noises that their tightening cycle may be over. Japan is easing and intervening in their currency. If China begins to reflate and the Chinese equity market is behaving as if something is changing, then the outlook for Asia/commodities changes. My point here is the CBs are turning bullish on money creation. As a result, inflation is about to pick up, though with some lag.

That's why the markets aren't behaving worse and financial crisis safe havens like the US Dollar aren't behaving better. They are discounting the possibility of policy intervention, which would buoy the prices of risky assets such as commodities.


Still a tug-of-war
So where are we today? The markets continue to be dominated by tail-event headline risk. On one hand, it's fearful of the macro risks such as a eurozone banking crisis. If calamity strikes, it's a long way down from here. On the other hand, the possibility of central bank intervention lurks around the corner. In the meantime, the drip-drip-drip of news that we have avoided the firing squad one more day, e.g. Papandreou's vote of confidence, are prompting the rallies and provides an upward bias for equity markets.

I wrote in last week's post, Defying gravity, that my base case for the next few weeks remains a sideways market with a slight bullish bias and I continue to stick with that view:

While I recognize that the macro risks are enormous, but do you want to take the chance and step in front of a trillion or two of central bank stimulus?

Until the risks are resolved one way or the other, the markets are likely to be volatile, news-driven and range-bound.



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 be too eager to get bearish

While the stock selloff in the last two days has been breathtaking, (just as the rally last week was breathtaking), even if you are bearish, I wouldn't be too eager to commit to a bearish trade here. There are just too many bullish triggers over the next few days that could rip the face off anyone positioned to the short side.

First of all, the market just kissed the 50% retracement support level as shown by the chart below.

Another short-term bullish data point came from Marty Chenard at stocktiming.com. He showed that, as of Monday night, institutional investors haven't panicked and the positive momentum seen last week appears to be intact.


The Greek referendum a domestic power play?
The news of the Greek referendum called by prime minister Papandreou caught investors by surprise yesterday and the markets sold off. Upon closer examination, the referendum story just didn't make sense. He caught his own cabinet by surprise with the news and even his own finance minister wasn't briefed on the plan. Joseph Cotterill of FT Alphaville wrote that it wasn't clear that Papandreou may not have had the votes to pass the referendum bill in parliament. Moreover, the Greek constitution specifically prohibits referendums on fiscal matters. So what would the referendum question be?

If the question were to be phrased in the form of, "Are you in favor of knuckling under to the EU and the IMF?" The answer would be an overwhelming "No". On the other hand, if the choice was to be accepting the austerity package as a price for staying in the eurozone, or to leave the eurozone and be ejected from the EU, then the outcome is much hard to predict.


Beware the Bernanke Put
I also wrote that bears should be careful about the possibility of central bank intervention (see Defying gravity and  When will bad news be good news?). We have the FOMC decision today and press conference afterwards. Consider, for example, this analysis of how far the Fed has strayed from its dual mandate and tell me that there's no Fed intervention risk.

What about the Draghi Put?
Not much is know about the views of Mario Draghi, but there are some insights to be had in a speech he gave in July 2011. First, he gives lip service to the idea that EU states must stand on their own [emphasis added]:

For years interest rates in the various parts of the euro area did not diverge significantly from those obtaining in Germany. For a long time the spreads between sovereign securities and German Bunds remained narrow and the interest rates charged by banks reflected the credibility of the public securities of the euro-area countries. This is no longer the case: the solvency of sovereign states has ceased to be a foregone conclusion but something that has to be won in the field with rapid and sustainable growth, which is only possible with sound public finances. Interest rates reflect today’s new situation: they are higher for countries with low growth and weaker public finances. The cloak of credibility provided by the stronger euro-area countries has been lifted; we must grow without relying on its shelter. The structural reforms invoked for years are now even more crucial.

In the next breath, Draghi goes on to talk about "innovative" monetary policy and "more appropriate set of economic governance tools", which is a signal that he may be more pragmatic than his predecessors in their approach to central banking:

On several occasions I have noted that Europe reacted to the global financial crisis by drawing on the credibility of the ECB and the latter’s timely and innovative conduct of monetary policy and by equipping itself with a more appropriate set of economic governance tools. We now have a system of autonomous authorities for banking and financial supervision, a European body to monitor and mitigate systemic risks, and new procedures for the coordination of fiscal and structural policies.

On last Wednesday, just as the eurozone summit was about to convene, Draghi "independently" released a statement that he supported the continuation of the ECB program of buying sovereign debt. That program was supposed to be discontinued when the EFSF came into being. It sounded just a little bit too orchestrated to me. To understand the significance of this statement, Brad Delong sounded off on the ECB's refusal to be the lender of last resort to the eurozone:

When the European Central Bank announced its program of government-bond purchases, it let financial markets know that it thoroughly disliked the idea, was not fully committed to it, and would reverse the policy as soon as it could. Indeed, the ECB proclaimed its belief that the stabilization of government-bond prices brought about by such purchases would be only temporary.

It is difficult to think of a more self-defeating way to implement a bond-purchase program. By making it clear from the outset that it did not trust its own policy, the ECB practically guaranteed its failure. If it so evidently lacked confidence in the very bonds that it was buying, why should investors feel any differently?

The ECB continues to believe that financial stability is not part of its core business. As its outgoing president, Jean-Claude Trichet, put it, the ECB has “only one needle on [its] compass, and that is inflation.” The ECB’s refusal to be a lender of last resort forced the creation of a surrogate institution, the European Financial Stability Mechanism.

Did Draghi just signal that a Draghi ECB is ready to embrace its responsibility as lender of last resort and to move off the one needle on its compass? Then take a look at Felix Salmon's account of what happened at MF Global, which was essentially a leveraged credit bet gone wrong. The story of MF Global is a cautionary tale of how quickly a financial institution can go south should it lose its liquidity funding. Is the ECB watching this is this scaring them?

What's more, did anyone catch the odd language at last G20 communique?

We remain committed to take all necessary actions to preserve the stability of banking systems and financial markets. We will ensure that banks are adequately capitalized and have sufficient access to funding to deal with current risks. Central banks have recently taken decisive actions to defend, and will continue to stand ready to provide liquidity to, banks as required. Monetary policies will maintain price stability and continue to support economic recovery.

When did the ECB's mandate include supporting economic growth and recovery? Or was the G20 referring to other central banks?


The Red Knight to the rescue?
Moreover, there have been hints of Chinese intervention. In the wake of the disappointing Chinese PMI release, Global Macro Monitor asked:

Interesting official PMI was less than the HSBC PMI, which was also released today. Are they paving the way data for an easing of monetary policy or to justify contributing to the Eurozone bailout? Just askin’.

I wrote before that Chinese appear to be signaling a policy of selective stimulus, these "hints" may be part of that campaign.


Don't get bearish too soon
In conclusion, I know that the headlines and recent price action look dire, but I would be cautious about getting bearish too early. The technical backdrop is improving for the bulls and as we face two back-to-back event risk days where central banks may signal imminent intervention.

Even if you are a bear, wait for a rally before putting on short positions. Sell into strength, not weakness.

Even if you are a bear and believe that the Fed, ECB or PBoC can't save the world, they can still rip your face off with a trillion or two of quantitative easing.




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.

When will bad news be good news?

The ink is barely dry on the eurozone Grand Rescue Plan and now we have a chorus of "it won't work". I was part of that chorus (see my previous posts here and here). Over the weekend, the bad news kept on coming:

• Greek prime minister George Papandreou has proposed a referendum early next year on the wildly unpopular rescue package. I wrote here that the success of the Grand Rescue Plan depends on the cooperation of the Greek Street and thought that they would acquiesce as long as no further austerity cuts were asked of them. Now that assumption seems to be unraveling.
• Portugal is unraveling and asking for a bailout. Analysis from John Hussman indicates that the implied default probability from Portuguese bonds is somewhere between 68% and almost 100% within two years.
• Chinese premier Wen Jiabao has pledged to maintain curbs on the Chinese property market.
• China has signaled that it will not be the savior of Europe.
• The 10-year Italy-Bund spread is blowing out. Though Macro Man postulates that the selloff in Italian bonds is a natural reaction because investors don't trust the sovereign CDS market because the rules can be changed so defaults become "voluntary". As a result, they are shorting Italian paper as a hedge.

While the news appears to be bearish, I also wrote in my last post to beware the policy response. We have the FOMC meeting this week and the subsequent press conference on Wednesday and the ECB rate decision and press conference on Thursday.

Will the Bernanke Fed stay with the message of "we can't do anymore, it's up to fiscal policy" message in order to put more pressure on the deadlocked Super Committee? Or will the doves win the day and signal it is willing to undertake QE3, which will likely be in the form of MBS purchases, were the economy to weaken further?

What about the Draghi ECB? Will it lower interest rates? Or will Draghi show the Germans that he is more German than the Germans in the price stability message. Ed Yardeni may already have an answer to that question. The (Trichet) ECB has already been quietly expanding its balance sheet, perhaps as a sign of pragmatism or a precursor to QE.

While I hate conspiracy theories, these actions by the ECB suggest that a backroom deal had been done. First, on the day that the Grand Rescue Plan was announced, Mario Draghi "independently" asserted that he supports continuing the ECB program of sovereign (read: periphery country) bond purchases, which was supposed to be temporary and end when the EFSF came into being. Now we find out that the ECB under Trichet has been expanding its balance sheet, albeit in a minor way.

Putting it all together, these signs point to an imminent ECB easing and friendlier environment for quantitative easing in Frankfurt.


Watching for a shift in market psychology
For me, the most important "tell" of market psychology is how it reacts to good news and bad news. Supposing that the Fed and ECB were to signal tilts towards easier monetary policy this week. Bruce Krasting wrote that the September NFP figures may have been unusually strong because it had five Fridays, which meant that people getting paid every two weeks may have received three paychecks and that Five-Friday effect would have distorted the economic releases for September. By contrast, October 2010 had five Fridays but October 2011 only had four Fridays, which could lead to disappointment on a yoy basis.

Supposing that Krasting is correct and the NFP release next Monday is disappointing. If the Fed were to signal a more accommodative monetary policy based on further economic weakness, will bad news become good news for the equity markets?



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.

Defying gravity

Something has changed within me

Something is not the same

I'm through with playing by the rules

Of someone else's game

Too late for second-guessing

Too late to go back to sleep

It's time to trust my instincts

Close my eyes: and leap!

It's time to try defying gravity

I think I'll try defying gravity

And you can't pull me down!

- Defying Gravity lyrics, from Wicked

The rally in risky assets in reaction to the EU Grand Rescue Plan was awesome to behold as the risky assets seemed to defy gravity despite grave concerns expressed by analysts over the details of the plan. The rally has unleashed a tsuanmi of positive price momentum. However, medium term concerns from cyclical indicators, measures of risk aversion and macro concerns over the sustainability of the eurozone "fix" leaves me to believe that we are undergoing a consolidation phase with an upward bias in the next few months.

I would be inclined to become more cautious about the outlook for equities and other risky assets in the 1Q and 2Q of 2012. My Inflation-Deflation Timer Model agrees with this assessment and has moved to a "neutral" from a "deflation" reading, which would orient the model portfolio from a bond heavy tilt to a more balanced weighting between stocks and bonds.

In the meantime, enjoy the spectacle of stocks defying macro-risk gravity.


Powerful momentum
To see how powerful the momentum is, you just have to look at the chart of the SPX. It shows that the index not only rallied through a downtrend line, but through resistance at the 1260 level and the 200 day moving average. Does this mean that the tide has turned and it's now up, up and away from now on?

Charts from a number of major equity averages around the world seem to suggest that bullish view. The FTSE 100 shows a similar pattern of a rally to test the 200 day moving average.

Even the Euro STOXX 50 shows a pattern of a turnaround. It broke through a downtrend line and the index is now in a minor uptrend, though the rally hasn't quite reached the 200 day moving average yet.

Moving eastward, even the Hang Seng Index has shown a pattern of strength by rallying through an important multi-year resistance zone.

Cyclical red flags
While the short-term momentum has been impressive, cyclical indicators are not sounding the all clear signal just yet. The resource-heavy and cyclically oriented Canadian equity market is showing a pattern of a rally through a short-term downtrend, but the longer term downtrend remains intact.

Commodities are also telling a similar story of a counter-trend rally within a longer term downtrend.

The Shanghai Composite isn't looking as healthy as Hong Kong or the other major equity averages around the world as it is struggling at the site of the 50 day moving average as well as a major resistance zone.

Inter-market analysis confirms my cyclical concerns. The relative performance of the Morgan Stanley Cyclical Index against the market also shows a pattern of a counter-trend rally within the context of a longer term relative downtrend.

Risk appetite returns, but...
Measures of risk appetite are also telling a similar story of a retracement within a longer term downtrend. Consider, for example, the performance of the NASDAQ Composite against the large cap NASDAQ 100. The ratio rallied through a relative downtrend line, but it has barely retraced much of the technical damage done when the risk aversion trade began in July. This chart suggest to me that the current rally has further to go, but a more realistic expectation would be a period of sideways consolidation with an upward bias. Longer term, this trade has the potential to go down further.

The relative performance of JNK (junk bonds) against IEF (7-10 year Treasuries) also show a similar pattern of rally through a short-term downtrend, but the longer term downtrend remains intact.

Macro concerns
On the macro-economic front, grave concerns remain. I detailed in my last post some of the concerns over weakness of the eurozone rescue plan (with new comments in brackets):

• European banks could send Europe into a deep recession. I wrote before that banks are asked to recapitalize to the tune of €100 billion, but the total market float of these banks is about €200 billion. Any plan that raises that much equity in such a short time will crater bank stocks. Bank CEOs have the alternative of getting to their 9% target by calling in loans, which would create a credit crunch that sends Europe into a deep recession.
• How good is the EFSF monocline insurance guarantee? Individual EU states are only guaranteeing their contribution the EFSF and have not actually funded their portion of the contribution. So when the EFSF insurance scheme “guarantees” the first 20% of a Spanish bond, part of the guarantee comes from Spain. If Spain were to get into trouble, can investors depend on the Spanish guarantee? In that light, how big is the real size of the EFSF monoline insurance scheme? [In addition, the WSJ also asked a very good question about regulatory risk surrounding the EFSF: "If Greek CDS don't trigger, why would EFSF?"]
• EFSF insured bonds create a two-tiered bond market in Europe. What will happen to currently outstanding bonds of troubled countries should there another credit event with, say, Portuguese bonds? [That appears to be less of a concern as the EFSF has indicated that credit protection will be detachable from the new bonds issued with such protection.]
• Greece is still struggling under the burden of an enormous debt. Even with the “voluntary” haircut, Greek debt will be 120% of GDP, which is above the 100% 90% of GDP benchmark that most analysts Rogoff and Reinhart consider to be a sustainable level for sovereign debt. Will Greece have to come to the table again for relief in the future?
• Could Portugal be the next Greece? The Portuguese debt burden does not appear to be sustainable and many analysts believe that Portugal is the next Greece. This deal only grants relief to Greece and does not put a sufficient ring-fence around the other peripheral countries. The current prescription of more austerity is only likely, in the short-run, to exacerbate budget deficits and send fragile EU member state budgets like Portugal and Italy over the edge. [Already, Portugal is showing signs of unraveling and going down the Grecian path.]
• What does the EU do when Portugal or Ireland asks for debt relief? When they rescued their banks in 2008-9, the Irish understood that they would be offered the same deal as Greece if there was a deal to be done on debt relief. Already, the Irish are seeking some form of debt relief. How will the EU respond?

Add these concerns to the European worry list:

• Pressures are showing up again in the bond market. The Italian bond auction on Friday did not go well. 10-year yields surged to new highs at 6.06% and they sold only €7.93 billion of bonds, which was under the €8.5 billion maximum.
• The EFSF's AAA credit rating depends on the French AAA. The WSJ reported that Standard and Poors has affirmed the EFSF AAA rating, but that rating depends on the credit rating of contributing member states, several of which have been downgraded recently. This puts incredible pressure on France to retain its AAA rating.
• Will ISDA declare the *cough* "voluntary" haircut to be a credit event? The beleaguered ISDA has a hard decision to make. It certainly walks like like a duck and quacks like a duck, but will it declare the "voluntary" haircut to be a default credit event and trigger all the credit default swaps sold on Greek debt and throw the global financial system into turmoil? Fitch has already weighed in stated that they believe that the "voluntary" 50% haircut and debt exchange would constitute a default. Macro Man has likened the discussion with the ISDA to the Monty Python dead parrot. Here is an excerpt (for full details click on Macro Man link above):

"I wish to complain about this CDS what I purchased not half a year ago from this very investment bank"
"Oh yes, the Hellenic Republic... What's wrong with it?"
"It's not paid out, that's what's wrong with it."
"No, no, it's just voluntary, look."
"Look my lad, I know a dead product when I see one, and I'm looking at one right now"
"No, no, it's not dead, it's just voluntary."
"Voluntary?!"
"Yeah... remarkable product, Sovereign CDS... beautiful name, innit?"
"The name don't enter into it. It's not paid out."
"Nah, nah... it's voluntary"

To put it all into context, here is what STRATFOR, writing before the Grand Rescue Plan was announced, thought about how Europe would resolve its Greek problem:

All roads lead to *ahem* Rome. I guess that's why George Soros thinks that the current rescue plan will hold together between "one day and three months".


The trouble doesn't stop in Europe
Meanwhile, there are signs of trouble in China. Consider:

• There are signs of stress in trade finance amongst Chinese private (non-state owned) companies.
• Shanghai property prices are falling, which has prompted protests at developer offices by homeowners who bought in at higher prices. These protests show that the property bubble is deflating not just in the peripheral markets, but the weakness has spread to the core markets such as Shanghai. We know from experience over the last few years what a popped bubble can look like and it's not pretty.

Last but not least, we have a looming recession in the US. In addition, the Super Committee to reduce the budget deficit appears to be deadlocked, and Merrill Lynch analyst Ethan Harris believes that inaction may prompt a credit rating downgrade of US debt by either Fitch or Moody's.

Ouch!


Don't forget the policy response
To investors who see these macro risks as dire warnings of a calamity, I would say, "Don't forget to think about the policy response."

I wrote that central bankers are planning a party and I believe that's what the markets are beginning to discount. Elements of the Federal Reserve are pushing for QE3 in the form of MBS purchases and there appear to be good reasons to undertake such a step.

Incoming ECB head Mario Draghi also signaled a subtle change in ECB policy last Wednesday by supporting the continuation the program of sovereign debt purchases, which was supposed to be temporary and discontinued when the EFSF comes into being. This represents the first step in a slippery slope to ECB quantitative easing, and even permabear Albert Edwards believes that ECB will eventually be forced to embrace QE. One key test of the direction of the Draghi ECB is its interest rate decision this Thursday.

In China, the authorities are getting ready for a policy of selective stimulus by cutting reserve requirements. The Chinese have maintained a policy of either stomping on the accelerator or stomping on the brakes. This latest move is a signal that they may be taking the foot off the brake and they are starting to step on the accelerator again.

While I recognize that the macro risks are enormous, but do you want to take the chance and step in front of a trillion or two of central bank stimulus?


Sideways consolidation with an upward bias
If asked to give an opinion as to future market direction, I would have to say that your stance would depend on your time horizon. Given the tremendous bullish momentum shown by equities last week and the technical damage done to the bearish case, my inner trader would say that in the short-term, his best guess is a sideways consolidation with an upward bias. The bull case is underpinned by the fact that we are moving into a period of positive seasonality and the likelihood that the markets start to discount the possibility of Fed and ECB intervention.

Watch the FOMC statement and Bernanke press conference this week for language that tilts towards another form of QE, or under what circumstances they would become more stimulative. Also watch the ECB decision Thursday. If either central bank shows signs of further accommodation, then the news could spark off another melt-up in equity prices.

My inner investor, on the other hand, believes that in the medium term, the eurozone Grand Rescue Plan is deeply flawed at many levels. Moreover, if the Fed does not signal that it is tilting towards greater accommodation by its December meeting, then the markets could be in for a rude shock should the economy start to slide into a recession. Early next year, Portugal could blow up and become the next Greece. Ireland may kick up a fuss and demand debt relief. There is also the dynamics of the French presidential election in the spring, which could create further volatility in the markets.

Those are things to worry about in 1Q or 2Q. Meanwhile, enjoy the rally.


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.

Central bankers plan a party

So now we have the EU Grand Rescue Plan. I wrote before that the success of any short-term rescue plan depend on the cooperation of the EU, the ECB and the Greek Street. (Also see Ambrose Evans-Pritchard's comment: Europe's grand gamble risks failure without ECB). I believe that the plan is deeply flawed for many reasons and only kicks the can down the road for a few months, but the key its short-term success is the cooperation of the European Central Bank.

In a "separate" statement yesterday, Mario Draghi said that he would support continuing the ECB's program to buy the sovereign bonds of periphery countries. This program was supposed to be temporary and end when the EFSF came into being. Such a statement is an important signal that a Draghi ECB is more pragmatic and more likely to print money if conditions warranted. Even permabear Albert Edwards believes that ECB will eventually be forced to engage in quantitative easing.

Great, so the ECB is on board, which should alleviate short-term pressures. There are, nevertheless, some major problems with the Grand Rescue Plan:

• European banks could send Europe into a deep recession. I wrote before that banks are asked to recapitalize to the tune of €100 billion, but the total market float of these banks is about €200 billion. Any plan that raises that much equity in such a short time will crater bank stocks. Bank CEOs have the alternative of getting to their 9% target by calling in loans, which would create a credit crunch that sends Europe into a deep recession.
• How good is the EFSF monocline insurance guarantee? Individual EU states are only guaranteeing their contribution the EFSF and have not actually funded their portion of the contribution. So when the EFSF insurance scheme “guarantees” the first 20% of a Spanish bond, part of the guarantee comes from Spain. If Spain were to get into trouble, can investors depend on the Spanish guarantee? In that light, how big is the real size of the EFSF monoline insurance scheme?
• EFSF insured bonds create a two-tiered bond market in Europe. What will happen to currently outstanding bonds of troubled countries should there another credit event with, say, Portuguese bonds?
• Greece is still struggling under the burden of an enormous debt. Even with the “voluntary” haircut, Greek debt will be 120% of GDP, which is above the 100% of GDP benchmark that most analysts consider to be a sustainable level for sovereign debt. Will Greece have to come to the table again for relief in the future?
• Could Portugal be the next Greece? The Portuguese debt burden does not appear to be sustainable and many analysts believe that Portugal is the next Greece. This deal only grants relief to Greece and does not put a sufficient ring-fence around the other peripheral countries. The current prescription of more austerity is only likely, in the short-run, to exacerbate budget deficits and send fragile EU member state budgets like Portugal and Italy over the edge.
• What does the EU do when Portugal or Ireland asks for debt relief? When they rescued their banks in 2008-9, the Irish understood that they would be offered the same deal as Greece if there was a deal to be done on debt relief. Already, the Irish are seeking some form of debt relief. How will the EU respond?

In brief, the participation of the ECB in the Grand Rescue Plan has put the immediate fear of a calamity on hold and kicked the can down the road. That road has many land mines, which I have outlined, and one of those land mines is likely to blow up in faces in the next few months.


Let's party like it's 2009!
In the meantime, the ECB appears to be planning a party. In addition, elements within the Federal Reserve have indicated that they support a form of QE3 in the form of large MBS purchases. As well, China also signaled that they are getting ready with selective forms of stimulus by cutting bank reserve requirements.

My inner trader is positively giddy at the prospect of central bank parties. He agrees with the sentiments of Cullen Roche of Pragmatic Capitalism, "Don't fade government intervention." Just look at the last party that was sparked by QE2. These parties tend to push the price of stocks and other risky assets to significantly higher levels. He says, "Don't worry, be happy."

My inner investors is prepared to show his face at the party, just to be friendly, but he is wary of the cops who are prepared to raid the party and he knows that they are lurking on the next block. This party may last for 2-4 months, but the downside risk is considerable should we see another policy mistake or market accident. He agrees with the analysis of Barry Ritholz, who wrote these words before the melt-up rally yesterday:

[Y]our posture is dramatically impacted by your time frame. If you are looking out 1-3 months, you are probably bullish. If your outlook is measured in 6-12 months, you might be less sanguine. And the time between is anyone’s guess . . .

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 poisoned bank recap chalice

We don't have the full details of the eurozone Grand Plan to be unveiled on Wednesday, but some details are clear. One of the key components of the proposal is to force a number of major European banks to recapitalize their capital base to 9% within a relatively short period. Banks would be encouraged to seek capital privately first. If that is not available, the bank could then turn to the individual member state, and failing that, to the EFSF.

This is a version of the Swedish solution, whereby shareholders and bondholders take the first hit in any recapitalization before the state injects equity. I have long been an advocate of this approach, but even that proposal needs a re-think. That's because the eurozone problem stems from too much sovereign debt accumulated by a number of EU member states and much of that debt was stuffed into eurozone banks. So the solution of the state rescuing the banks who lent the state too much money becomes a circular problem of trying to insure yourself.

What's more, the spectacle of EU states trying to rescue themselves has become too big. John Hussman put some scale to the size of the problem this week [emphasis added]:

My guess is that European leaders will force a bank recapitalization within days - probably 100 billion euros, preferably 200 billion, but the larger number is doubtful because at present market values, European banks would have to sell new shares in nearly the same quantity as their current outstanding float in order to acquire the new capital. Yet Stratfor correctly notes that even in the event of a 200 billion recapitalization, a 50% haircut on Greek debt "would absorb more than half of that 200 billion euros. A mere 8 percent haircut on Italian debt would absorb the remainder." So a good chunk of the present EFSF could end up recapitalizing banks, especially if too little is raised from private investors. This would leave little ammunition against any further strains, should they develop.

The current rumor is that size of the forced bank recapitalization will be about  €108 billion, which would be roughly half the value of market float at current prices. Bank CEOs who are incentivized by their share prices would be highly reluctant to go to the market and dilute their equity base by being a forced seller. By demanding that banks recapitalize quickly, the risks is that banks shrink their balance sheet by calling in loans in order to conform with the 9% capital target. This would result in an old-fashioned credit crunch, and in the face of the latest European PMI already pointing to recessionary conditions, such a policy would topple Europe's fragile economy into a deeper abyss.


€2 trillion = 20% of global FX reserves
If those aren't the solutions, then where else could the EU get the money? I wrote on Sunday that Europe has three choices:

• Get more money internally from the strong states within the EU such as Germany;
• Get more money externally, e.g. the US or BRIC countries; or
• The ECB prints the money.

Given that Merkel is already on thin ice by asking the Bundestag to approve the latest EFSF proposals, the prospect of more funds from Germany is off the table. What about the United States, BRIC and Gulf State SWFs? While stories such as Norway's SWF is ready to invest are helpful, STRATFOR (sorry no link) put the scale of the problem into context:

[T]o put the magnitude of Europe’s crisis in context, it would take nearly 20 percent of the worlds accumulated foreign exchange reserves to account for the approximately 2 trillion euros needed to contain the EU debt crisis for a mere 3 years. The unlikelihood of such funds materializing is compounded by the fact that most of the foreign currency reserves are held by low-income countries with little political room to bail out one of the world’s wealthiest economic zones.

The kinds of shock-and-awe eurozone rescue figures that have been bandied about have been in the order of €2 trillion, which amounts to roughly 20% of global foreign exchange reserves? China has already signaled its reluctance to step up and help in a meaningful way. How likely are the other emerging market countries come to the rescue?

In short, forcing European banks to drink from the poisoned bank recapitalization chalice today could the policy mistake that plunges Europe and the world into a synchronized global slowdown. Don't expect other players, such as the IMF or emerging market economies to come to the rescue because the scale of the problem is just too big.

I guess it's all up to Super Mario now.



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.

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