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

Friday, 30 March 2012

Eurozone's Perpetual Monetisation Machine

European leaders gather to debate and construct a hopelessly inadequate firewall in their attempt to contain a nuclear meltdown. Despite their pessimism, markets remain relatively sanguine. Even after the recent sell-off, yields and CDS spreads remain well below the distressed levels they reached at the end of 2011. The Euro has also recovered 6% from its recent lows. Market performance in the first quarter of this year is largely due to ECB’s LTROs. It took funding pressure off the banks, provided ammunition to the carry traders and injected misplaced optimism (otherwise known as hopium) into market participants. At some point, LTRO effects will wear off since hopium has a short half-life. Waning confidence will put the funding pressure back on as non-domestic investors pull back and carry traders panic as usual. So far there is nothing new. The same old pattern will reassert itself.

The crisis seems to be a death spiral with hope leading to confidence which degenerates into despair and hope again rising from the depths. But what is different about each successive spiral is the strengthening of the moral hazard engendered by each successive policy intervention. Therefore the sovereign-bank default correlations are tending to one as domestic banks take ECB’s money to load up on sovereign debt. Counterintuitively, this is the reason to be positive on the Eurozone. It benefits sovereigns as deficits are indirectly monetised through their banks. Moreover, as banks act as one to support the sovereign, this monetisation can continue indefinitely or until ECB pulls the plug.

The peripheral sovereigns have chanced upon the perpetual monetisation machine which can potentially keep insolvency at bay. The machine can potentially provide enough time for structural reforms to have an effect. It enables sovereigns to “miss” austerity targets in the short term as they try to turn their economies around. 

But as always, there is a problem. Domestic banks cannot expand their balance sheet to buy their entire sovereign’s debt. Since secondary spreads are a gauge of solvency, lack of confidence on part of non-domestic investors will lead to widening spreads and eventual breakdown. Even though Rajoy has the right idea about increasing the deficit in the short-term, investors aren’t going to wait around to see whether it works or not. A look at Ireland and Portugal makes it clear. They kept protesting that they didn’t need a bailout until investor stampede forced the EU to generously take IMF’s money and give it to them.

Supporting secondary market spreads is difficult. Guerrilla tactics of domestic banks making repo, and thus shorting bonds, expensive will not work. For one they do not have enough bonds and two, the widening is primarily due to investors selling what they own. The Eurozone only has two bullets which it can use against ‘evil speculators who do not appreciate the fundamental strength of the Eurozone’. The first is SMP and the second is the more nebulous intention of EFSF to buy bonds. The problem with the former is that it is collateral constrained. With the Bundesbank watching over its shoulder, the ECB has to sterilise SMP buying. If foreigners sell bonds and flee with their money, SMP leads to a horrible constriction of money supply. The problem with EFSF is that at present it is more of ‘don’t worry we’ll sort it out’ than an intelligent executable plan.

An argument can be made that as long as the perpetual monetisation machine supports the primary market, the secondary market is irrelevant. After all Greece continued to issue T-bills below 4% until the debt-swap. While true, it ignores the larger ramifications of stratospheric sovereign secondary market spreads. As the gauge signals distress, all non-domestic and even some domestic investors will head for the door. They will take their money out of not just sovereign bonds but all investments. Companies sweeping cash balances of their subsidiaries in peripheral countries daily are just one example. The result will be a devastating credit crunch and depression. Greece is a case in point having experienced 9 successive quarters of GDP decline without an end in sight.      

Therefore the perpetual monetisation machine critically depends on the market being in a continued hopium stupor. For the time being LTRO-induced buying achieved this objective. As VaR limits were cut and dealer inventories ran low, it was easy for relatively small traded volume to have an outsized effect. Therefore domestic buying ramped up bond prices causing momentum traders and benchmarked investors to follow. Unfortunately optimism requires economic data to validate it; and this is missing.

Summits and firewalls are at best irrelevant and at worst a distraction. The market will turn at the point when domestics run out of excess LTRO liquidity or their bid is matched in a greater size by non-domestic institutions. The former can happen if redemptions outpace new issuance or deposit outflow accelerates. At that point the co-operative mode in this version of Prisoner's Dilemma will break down. The latter depends on sentiment based on political developments and economic data releases. The perpetual monetisation machine may still run, as Greek T-bill issuance demonstrated, but it'll be running on empty and only for a short while.

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