Eur-eversals

By: Michael Ashton | Thu, Nov 3, 2011
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Bonds traded poorly on Thursday, with 10-year yields rising 7bps in both nominal and real space. Commodities traded solidly, with contributions from every sector (energy, precious metals, industrial metals, etc).

Equities got hammered overnight, but then rallied into the open and (aside from a brief profit-taking dip right after the open) kept rallying throughout the day. The S&P added 1.9%.

The Greek situation got less clear, and equity investors seemed to figure that was an improvement. There were rumors that Papandreou would resign (which seems to have been incorrect) and that the referendum would be canceled. The market regards this latter rumor as fact, and it is factually accurate, but Papandreou still faces a confidence vote which will now end up being effectively a vote on whether to accept the deal or not. I am amazed that the referendum, which seemed like a masterstroke from Papandreou, was canceled - and I can't imagine that normal people in Greece are particularly pleased about having a voice in the matter snatched away by the Eurozone elit es. It reminds me of when Texas Governor (and now Presidential candidate) Rick Perry refused federal stimulus funds because of the many very-sticky strings that came attached. Mr. Perry took a lot of heat from people within the state for not taking what many citizens considered 'free money,' and had to make the case to the citizenry that they were better off without it. In this case, the strings are far more obvious, however.

There continue also to be mixed signals from the EU itself, with new ECB President Mario Draghi saying that exit from the Euro was "not in the treaty" but Angela Merkel saying that Greece's referendum needed to be whether or not to stay in the Euro. I continue to think that there's a strong case to be made that Greece is better off outside of the Euro, and just today TF Market Advisors made the case very clearly. I am going to take the unusual step of quoting a large section of their analysis here (with permission from TF Market Advisors, of course). They make the case that the argument of whether or not to be in the Eurozone could conceivably be framed as "debt slavery" versus "freedom." I find their description of what could conceivably happen if Greece left the Eurozone particularly compelling and hopeful, and phrased as a campaign argument for the referendum:

No Eurozone as Freedom and Sustainable Economic Growth (An analysis by TF Market Advisors)

The No vote needs a credible plan. Let's start with repudiating all existing debt. Merkozy says we are with them or against them; well, let's go for it. Not accepting your horrific bailout means we have to leave the Euro, then we are going to do this right. Greece will not make another payment on any existing debt. Debt to GDP is now 0. There are GREECE bonds and GGB bonds. The GREECE bonds may have some rights to fight this, as they are under English law, but the GGB bondholders are probably completely out of luck since they were done under Greek law. Not sure if you have looked, but the documentation on sovereign debt is pretty slim to begin with and very little is devoted to bondholder rights, since they have none. So step 1 is to stop paying on existing debt and we think it will work. Not only h as our debt to GDP ratio dropped to zero, but our annual budget deficit problem just got a lot smaller. With an average coupon of 4% on 350 billion of debt, the savings would be 14 billion euro per annum. That looks to be about 75% of the annual shortfall.

It is true that this will wipe out our banks. We cannot make special consideration for our banks. They made mistakes and have to be punished (but "wink wink" the banks have shifted so much risk to the ECB that it is really a problem for the ECB and we have no interest in making the ECB's problems smaller, since they are part of what we are leaving). Once the losses have gone through the system we will then nationalize the banks. All depositor accounts will be protected. Not a single cent held in a bank account will be lost. Yes this is a cost to the government and we will need some money for this, but rest assured, no bank accounts will experience a loss.

The nationalized banks will function and ensure the economy runs smoothly and will have a much more concentrated focus on Greece. You may hear some noise from the bankers that they won't work for nationalized banks, but that is all it is: noise. The computers will still run, and tellers can be replaced if they really want to quit, and frankly the senior management is what got us into the problem, so they may not be asked to stay anyways.

The pension system will also be hurt. We will be making a one-time contribution to the pension funds to make some of their losses, but it will be contingent on changes. Defaulting on our existing debt doesn't solve all the problems. Some of the austerity programs will have to be implemented and the citizens of Greece will share part of the burden of achieving sustainable economic growth. The cuts will not be as severe as those demanded by the EU, but more importantly, you, the people of Greece, are making these sacrifices for yourself and for future generations of proud Greek citizens.

So, we will need some money to nationalize the banks, cover all depositors, to reduce the damage to the pension system, and to pay bills until we are able to run without an annual deficit. To this end, we have our friends from the EU to thank. In their effort to strip us of our wealth many supported the "Eureca" plan. We realize that it was an attempt to strip us of our heritage and to enrich themselves at our expense, but not all of the ideas are bad. We will be auctioning off minority stakes in some of the entities. The winners will be required to not only pay for the minority stakes, but will participate in our new Drachma bond offering. We have already been approached by several potential investors. It seems that although the EU may be fair weather friends, many other nations are private investors are h appy to support the new Greece. Sovereign wealth funds in particular are excited to be part of the new Greece and are comfortable that with our incredibly small debtload, so not only will the new Drachma bonds trade well, there is little expectation of inflation. We have no need to "print" money like other central banks, because our debt to GDP ratio will only be 20% after the asset sales and new bond issues. With such low debt, many of the growth countries in the world will find it a valuable addition to their investment portfolio. We expect to have enhanced trade agreements with many of these countries shortly as well, in an effort to replace what the EU has decided to deny us.

There will be claims that this cannot work, yet look at Korea, Russia, Argentina, Iceland, to see countries that either defaulted or were on the precipice that made tough decisions, played hardball, and went on to unprecedented periods of prosperity.

Say no to the Eurozone and usher in a brand new era where we control our own destiny and have no debt problems, with a real possibility of having surpluses and reserves in the future. The new Drachma will be a solid currency backed by hard assets, a strong government, dedicated citizens, and little debt. Do not listen to the alarmists, they have everything to gain from keeping us bound to the eurozone debt shackles and everything to lose by us taking back our freedom.

The main takeaway here is that it is probably not the case that leaving the Eurozone leads to a new Ice Age. The standard of living of the average Greek will not recover to pre-crisis levels for some time, but that is true no matter what choice is made.

Market-wise: now that there is near-unanimity that Greece is going to accept the bailout after some whining, there is no longer upside to that uncertainty. Let us remember that before Greece started making noises about not liking the deal, lots of other observers gave the deal little chance of making any meaningful change in the ultimate probability of Greek default. Greek 2-year yields rose 95% today...which is an improvement over where they were earlier in the day, but still not exactly a ringing endorsement about the Grand Bargain for Greece. I am less than completely confident that when Monday comes we will still think Greece's problems are all solved.

Back to the new guy at the ECB. I am sure that many in the EU are saying "see what happens when we put an Italian in charge of the central bank?" No sooner did Mario Draghi take the helm at the ECB than the bank reversed the prior policy and cut interest rates unexpectedly. To be sure, Trichet's policy to tighten into a recession and sovereign/banking crisis was absurd, but no one expected a turnabout so quickly. However, we can now say that no major central bank can even plausibly claim to be tight. (The ECB with its bond purchases had already looked like it was pursuing easy money even while maintaining the façade of holding the line on inflation, but now their position is clear). Two central banks are literally printing money to try and weaken their currencies. Several are buying assets of all kinds. And incredibly , the fear of inflation is ebbing. Commodities' rally today was the right direction, but I fear they were moving in sympathy in stocks rather than because it makes all kinds of sense to be long real assets right now.

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On Friday, we finally get the Employment Report, with economists looking for a print around 100k on Payrolls and an unchanged 9.1% Unemployment Rate. Certainly all labor indicators right now seem to be suggesting such a status-quo-maintaining number. I suspect the markets will react more strongly to a weak number than to a strong number, simply because today made the 'strong economy' investments more expensive and it is also fairly easy to imagine profit-taking into the weekend anyway.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

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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