Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Thursday, 15 March 2012

Eurozone: Questioning the rally


Volatility is down, equity markets are up, peripheral bonds are rallying. European leaders seem to have solved the crisis. At least that’s what they’re telling voters. In this case, the cognitive bias of optimism has been elevated to the level of delusion. And not for the first time. Historical records are missing but I’m pretty sure that Roman officials tried to assuage residents that the crisis was over even as Alaric’s army was streaming down from the hills in 410AD.

This scepticism over “the solution” stems from the following:
  1. Trading volume is down sharply – this is an indicator of indecisiveness and lack of risk appetite amongst investors and dealers not a mark of confidence.
  2. Peripheral bond rally has been led by domestic buying and short covering – Draghi’s LTRO has funded moral hazard buying triggering stop losses, momentum buying and buying on fear of underperforming benchmark.
  3. Greek debt burden is still unsustainable and the economy is performing worse than expected – retail sales fell 11% YoY in December, Industrial production declined 5% YoY in January, GDP fell 7.5% in 2011 (6% was expected) and unemployment is now 20.7% jumping from 17.7%. Argentina defaulted 6 months, 20 days after its “voluntary” debt swap. Can Greece break the record?
  4. Peripheral economies are also performing worse then expected as illogical and unattainable austerity targets make a bad situation worse. Perversely large and increasing debt/GDP ratios mean that austerity will be forced one way or another.
  5. TARGET 2 imbalances aren't correcting – this is an indicator of private capital flight out of the periphery.
  6. The political decision-making process is still fractured and slow – decisions made due to peer pressure build up resentment and stress which boils over at the worst possible time.
Nothing goes up or down in a straight line (except perhaps Madoff’s returns) and current European sovereign credit spreads are no exception. Unless ECB monetises, the current calm rally will soon end. The same pattern has been repeated since 2007 – a tear inducing violent rally followed by a relatively calm period and the realisation that it isn’t over, not by a long shot. The only exception was 2009. This is not 2009.

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