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

Monday, 23 July 2012

Thoughts and trade ideas on Europe

On the 28th day of June 2012, the great leaders of Europe solved the crisis engulfing their cherished elitocracy. It was the 19th time that the crisis had been solved. Unfortunately God seems to be an evil speculator.

Spain is now at the point of no return with 10-year bond yields at 7.5% and the curve flattening fast. Without official intervention or assistance the market is unlikely to suddenly regain confidence and cause yields to revert to sustainable levels. Unfortunately neither is any credible intervention likely nor is there any will for it by the northern European creditor nations. Half-hearted attempts will be made (SMP reactivation is my guess) but apart from causing another short-lived sucker rally they are going to be ineffectual.

The next domino in the line is Italy. After that the barbarian hordes will be at the gates of the “special partner” whose bonds are ironically benefiting from flight to quality. The buyers must be using some complex mathematical formula whose understanding eludes the rest of the world. French CDS at 180bps when Spain is at 620bps and Italy at 540bps is the cheapest short available. The problem of course is that soon after French CDS starts its inexorable rise upwards, laws will be changed and the market made illegal. With this trade, timing is everything.

This is also the moment when the twin bazookas of EFSF and ESM turn into water pistols even in the eyes of the most ardent optimist. Spain guarantees 12.75% of EFSF and 11.904% of ESM. Italy further guarantees 19.18% of EFSF and 17.914% of ESM. The abstract problem of valuing an insolvent state’s guarantee on loans to itself has suddenly assumed practical dimensions.

With everyone concentrating on Spain and Italy, problems from the original schuld of Greece have moved to the periphery. This loss of focus is going to prove costly. IMF has threatened to withhold aid funds (Bloomberg story referencing original Spiegel article) due to Greece missing its bailout targets. If it does follow up on the threat then catastrophe beckons. Argentinian default on 23rd December 2001 happened after the IMF pulled the plug on further aid on 5th December. The remarks of the German Vice-Chancellor that Greek exit “had lost its terror” shows the cluelessness of decision makers. Unless he has turned into a fatalist, the implicit assertion that a Greek exit will be manageable is foolhardy.

Greece is not unique, it is merely the first. A Greek exit will set a precedent which will accelerate a collapse of the Eurozone. Trying to paint it as an isolated case is unlikely to work especially as credibility of Eurozone’s leaders is at its lows. PSI was supposed to be a one-off in Greece, investors are now assuming it for Portugal and others and pricing their bonds based on implicit official seniority. What matters is not whether the Greek precedent is actually followed in future, but the present belief in it being followed.

A Greek exit will result in a complete collapse of the economy as it is deluged by a tsunami of bank, corporate and household bankruptcies. Ordinary Greeks will see their savings and pensions evaporate overnight. Inflation will soar as the newly introduced Drachma plummets. The waves will hit the rest of the Eurozone through both private and official channels. The former will be hit by a redenomination of contracts and default while the latter will be hit by the repudiation of TARGET2 liabilities of the Bank of Greece. Further, seeing the plight of Greeks, citizens in other distressed countries will redouble their efforts in stuffing their mattresses with hard currency. Banks runs across the Eurozone will follow. A truly Creditanstalt moment.

Having dithered for so long and continually put good money after bad, there are no good choices left for European leaders. The silver lining is that there are still choices. If they continue in the same vein and hold a 20th summit and a 21st and so on then those choices will no longer be available. The key question is whether they want to stand their ground or retreat from the European Monetary Union (EMU). Advancing to a fiscal union is out of the question given the mismatch in expectations and the political opposition within member states. Everyone may want “more Europe” but they define it differently. By the time the disagreements can be ironed over, their position would have been overrun.

As I’ve argued before, standing ground at this stage requires monetisation. That will take away default risk and cause sovereign bond yields to drop. A fall in value of the Euro will make adjustment easier for uncompetitive peripheral economies. It is an implicit wealth transfer from Germany and other northern European countries but that is the price to pay for continuing with the EMU.

The second option is of an orderly retreat. Letting states exit the EMU but abide by all the other rules of the EU. This will lead to a disintegration of the Euro but the single market will be preserved. It has to be an overnight big bang exit with everyone who wants to leave out and the remaining nations still in the Euro. A sequential withdrawal will just lead to uncertainty and all the ills outlined above associated with a Greek exit. In practice it means the demise of the Euro since each country would opt for its own currency in order to fully control monetary policy to deal with the shock.

Unhappily, this option is also very costly as contract redenomination and defaults will follow. An initial peg of a national currency to the Euro for redenomination may make it easier but it is likely that capital controls will have to be introduced. Further, a redenomination of TARGET2 liabilities means a wealth transfer from northern Europe. However, de-facto the transfer has already taken place due to the actions till date. Whichever way this resolves itself, Germany is left holding the can. And the longer these continual crisis summits stretch the crisis, the bigger is going to be the eventual wealth transfer. 

Further attempts to buy time are likely to make these choices moot as disintegration starts through market contagion, bank runs and riots (the Argentine case). 

Therefore to an investor bearish on Europe the best way to express that opinion is through shorting the EUR against a basket (eg. USD, DKK, NOK, JPY). The reason is simple – as the crisis intensifies, interference in the market will increase through short selling bans, etc. Today’s announcement by Spain and Italy makes this very clear. Also, this interference is likely to turn nastier over time. Therefore shorts in equity or fixed income are at risk. In contrast, capital controls are likely to be the last option and are usually taken only at the bitter end (Argentina is a case in point). Moreover the liquidity of FX markets enables appropriate positions to be taken more easily.

Disclaimer: All ideas elucidated above should not be taken as investment recommendations. The reader should perform his/her own analysis before making any investments.

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