Beware the Great Unzipping

By: Michael Ashton | Sat, Jan 14, 2012
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It was a fitting conclusion to Friday the 13th when S&P, after the close of the markets for the week, announced a list of ratings downgrades for European sovereigns. There had been rumors throughout the day, and some leaks, but it wasn't until 4:30ET on Friday that we saw the list in full. Key among the downgrades were Austria and France, which fell from the ranks of the AAA. This means that the ESM probably won't be able to secure a AAA rating, which means its potential effectiveness (which was never likely to be enough anyway) declines, which means the ECB will need to shoulder more of the load. This they seem resigned to do, but we will have to see if it is going to be enough.

Also getting downgraded, in some cases to junk, were Cyprus, Italy, Portugal, Spain, Malta, Slovakia, and Slovenia. How far have Italy, Portugal, and Spain fallen that they are included in the same list of anything with Cyprus, Malta, Slovakia and Slovenia? Germany, as was expected, retained its AAA rating but somewhat surprisingly had its outlook upgraded to neutral. That seems wildly incoherent to me; unless the Euro breaks up almost immediately, there are too many drowning swimmers clutching at Germany. I cannot imagine she will not be dragged down too, eventually.

The downgrades are over (from S&P) for now, but there will be more in the future. S&P said France risks another downgrade if public debt and the deficit deteriorate further, which they almost certainly will. Note also that S&P didn't even consider as a possible scenario the breakup of the Eurozone, which is incredible - at the very least, it is possible!

S&P tactically waited until after markets were closed before making the former announcement, so as to give investors time to absorb the information and to coolly consider their next moves rather than reacting off the cuff. On the basis of the ratings changes, there would likely be a modest decline in the markets on Monday (in Europe), but there were no major surprises here and now that the deed is done, there will presumably be an interval before the next downgrades. I was hoping that 10-year French real yields would still be up around 1.25%-1.5% when the downgrades happened, since a spread of 150bps over the U.S. seems adequate and 1.5% isn't a horrible real yield. Unfortunately, after spiking over 2% in late November, those yields are now back slightly under 1%.

But for another reason, even if those yields rose back up I'd be reluctant to dive in until institutions are done selling their European sovereigns. Because while the weekend gave investors time to calmly consider their strategy and buy lists, it unfortunately also gave German Chancellor Merkel time to tell reporters that she'll consider legislation to "bar institutional investors such as insurance companies from selling bonds when ratings were downgraded." I'm not making that up. Let's hope that comment was taken out of context, but if it isn't clarified by Monday morning, I would assume most institutions would err on the side of dumping bonds they can still sell today, but may not be able to sell in the future. Honestly, I really think this must be a mistake. It's the stupidest thing I've ever heard.

And that's really saying something given the last year in Europe, isn't it?

Talks in Greece aimed at reaching agreement on the conditions (effectively) for continued disbursement of the rescue funds were suspended over a dispute about what coupon the new Greek debt would carry. That is clearly a nonsensical point of dispute since there's almost no chance the debt will be repaid no matter what the coupon. The only decision to be made here is whether Europe wants to flush another couple hundred billion Euros away in order to delay the default to a time that would be more convenient. The artificial argument here suggests to me that at least some of the bailout-providers have decided that throwing good money after bad in a Quixotic quest to prevent a default is not the best use of or political.

Now, there's no surprise here either. Greece is going to default, or equivalently they're going to leave the EZ and redenominate the debt into printed drachma. I still think the markets rally when Greece announces that it is going to default. Perhaps there will be a knee-jerk dip first. The more delicate question is what will happen when she leaves the Euro.

The Eurozone crisis has moved into slow-motion, which suits everyone. As long as no country leaves the Euro, the crisis can probably be kept in slow motion with the aid of heaping helpings of money from the ECB. But, if Greece leaves the Euro - and I think it will - then there can no longer be any illusion about the inviolacy of the currency unit. The removal of that illusion could cause the situation to unzip rapidly since of course if Greece can/must exit, then surely Spain, Portugal, and some other countries can/must as well. And since the exit of Spain from the Euro is, I think, not at all priced into the market: that is where you could get a rather violent reaction on the unzipping (especially in thin, illiquid markets such as we have currently).

In the meantime, the raw economic data is not great, but also not disastrous. I don't put any weight on the Initial Claims data at this time of year, and really for the next 2-3 weeks, so the rise in the figures this week don't concern me. The sag in Retail Sales (-0.2% ex-auto, compared to +0.3% expected) matters, especially since it was December Retail Sales. It was the first negative print since mid-2010, and worth watching. Again, I don't expect growth to implode here, but I also don't think the aggressive hopes of equity investors will be realized either. That said, M2 was also up $85bln last week (over year-end), putting the 52-week rise to 10.8%...a new high. That money will go somewhere - some of it into asset markets, and some of it into product markets. It is hard to be short anything here, but as I noted the other day I can easily justify being long inflation!



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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