Go Long Egg Cups

By: Michael Ashton | Tue, Jul 5, 2011
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Now that Greece has avoided the immediate default by promising whatever was necessary to get the latest tranche of aid, the real game has begun as the various players consider how to provide a longer-term Greek solution.

The ratings agencies have begun to break their studied silence and to express opinions on the "French" restructuring plans. Recall that a key point here is that if the ECB is to continue to accept Greek bonds as collateral, they cannot be defaulted. This is very important, because borrowing against those bonds is virtually the only source of funding for Greek banks. (I think, but am not sure, that they are also a source of cheap funding for other banks. If the bonds can be carried at par, are they discounted at the ECB at par? If so, then it would mean you can buy a bond trading at 60€ and use it to borrow 100€. I don't know the answer here, and I assume that game isn't allowed, but I mention it because one of my readers will surely know the right answer).

It seems incredible that there was any question that the plans would be considered to be anything but default, since the whole point is that Greece needs a way to pay back less than it would otherwise be obligated to. The 'voluntariness' is a bit of a red herring since any bond holder is going to 'voluntarily' take a deal that does not result in the meltdown of the global financial markets, which some analysts have threatened as the possible result if Greece defaults (I don't think the result would be so dire, although it would be bad). Any agreement is therefore suspect as being less-than-fully-voluntary, although there is lots of gray area to play with here.

S&P, on Monday, said that the Greek plan as currently formulated would probably be a default, and Fitch agreed. Moody's has not yet expressed a firm opinion. Quickly moving to isolate Moody's, a senior finance official at the ECB told the Financial Times that the central bank will continue to accept Greek debt as collateral for loans unless all of the ratings agencies declare it to be in default. The reasoning is that their "standards" allow them to consider the highest rating among the big three ratings agencies. But the real reason is that this helps to put a wedge between the ratings agencies. Each of them now needs to fear whether one of the others could be bought, and whether they should instead sell out first when there is still an advantage to doing so. Perhaps that sounds cynical, although of course I don't mean explicitly bought, but it is much easier to bring pressure to bear on the individual members of a cartel than to bring pressure on the cartel generally.

Meanwhile, adding to the creepy unreality of all of this was the report from ISDA (the International Swap Dealers' Association, which is the main arbiter for the question of whether a standard CDS event has been recorded) that the French plan probably wouldn't constitute a default in the meaning of a CDS contract. This bizarre conclusion raises the possibility that banks and hedge funds which owned the debt with CDS protection are going to get killed on both sides of the plan, with the debt going into recovery and the CDS protection being worthless. Some credit arb funds will get crushed as a result (one hopes that they have strict risk limits that contain the damage from one such event); arguably, credit arb as a strategy class in the hedge fund world just took a big hit as a concept, if at least two of the major agencies can declare a default and it doesn't trigger a CDS contract. Supposedly, the reasoning is that the "period of selective default" might be short enough to essentially be ignored.

Really? If so, that's a very slippery slope. What counts as default, then? Five days in default? Ten? Thirty? Or does it depend on how important the issuer is? I am no expert on CDS, but this seems crazy to me.

Stocks and bonds were both comparatively quiet, retracing small amounts of last week's moves. Bonds did better and stocks set back a bit when Moody's this afternoon cut Portugal's debt to junk. Right, Portugal: forgot all about them, didn't we? Of course, if there's no such thing as default, who cares about a rating that tells you how likely a default is?

Commodities prices, though, were fairly active, with the DJ-UBS spot index climbing 1.6%. Energy, Grains, Livestock, Softs, Precious and Industrial Metals all rose, despite the fact that the dollar also rose. The chart damage is far from undone, but our asset allocation models continue to be heavily weighted towards commodities and cash.

But no matter how you get your inflation protection, get your inflation protection. A clearer signal on this point there couldn't be, than the fact that Congressman (and Presidential Candidate) Ron Paul - the ultimate hard-money advocate - is advocating monetization of the debt by having the Fed tear up the IOUs that they hold from the Treasury. That is, the Fed issued $1.6 trillion in electronic money to buy Treasuries; now, rip up the Treasuries. This is no different from if the Fed had simply printed $1.6 trillion and given it to the Treasury to buy goods and services or transfer directly to individuals through the tax system. And the fact that the idea is coming from Ron Paul, of all people, should be chilling. Even people who want 'hard' money are thinking it may not be feasible without a little monetization/debasing first!

The author of that article suggests that the Fed could sop up the liquidity it would otherwise have drained when it sold its portfolio of Treasuries by something simple like raising the reserve requirement for banks. This would probably work, although it is a blunt measure with lots of uncertainty about its effects since no important change in the reserve requirement has been made in around 30 years. But that would of course be devastating for bank earnings in the long run since it would forcibly reduce financial leverage (although see my note back in May about excess reserves and the unintentional reduction of leverage at banks).

In a month...no, a year...no, an era of crazy ideas, chalk up another. But do take note of my point that when even the chickens start to vote for boiled eggs, it may be time to invest in an egg cup because breakfast is on its way.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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