Dueling Prophets

By: Michael Ashton | Mon, Mar 5, 2012
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What promises to be a fairly interesting week started slowly. I expected that over the weekend we would have started to hear about private holders of Greek debt that would announce plans to tender their bonds in the PSI.

And we did not.

Surely, prior to releasing the details of the PSI, Greece and the Troika had orchestrated such announcements, in order to create a sense of momentum, of fait accompli? To fail to do so is just another gross incompetence, another terrible mistake on something it is easy to get right. Behavior matters; perception matters. Make those planning to hold out feel some pressure early...but they didn't, which creates the opposite impression - "hey, they don't have the votes!" And so today, we finally heard from holders that the IIF represented, and we learned that group only amounts to about a third of the bonds outstanding. That's it?

Meanwhile, hedge funds account for about ¼ of the bonds. Now, I am not one of those who think it's automatic that evil hedge funds will hold out (although if they're exploiting the dummies who put this together, I almost need to cheer), since hedge funds understand that their continued existence is subject to the whims of regulators. Hedge funds, while motivated by lucre, are generally motivated by long-term lucre. On the other hand, it's probably also fair to surmise that the ones who didn't want to be involved in what is likely to cast their firms in a negative light have already sold their bonds and that therefore most of the ones remaining are not planning to tender.

Since Greece needs 2/3 of the bonds to tender and 1/3 has said yes while ¼ is likely to say no, it follows that about 80% of the remaining bonds need to be tendered or the PSI will fail. I think that's a possibility, but in any event the success of the PSI certainly isn't the sure thing that has been factored into the market in the days since the deal was announced.

So will the default, if it happens, and the likely exit of Greece from the Eurozone, end all multi-cellular life[1] on the planet?

One answer to that question was carefully leaked today by the IIF, the organization which was responsible for negotiating the surrender Private Sector Initiative. It falls squarely in the camp of "a disaster of epic proportions," and predicts that certainly every possible pestilence will befall the planet (with the possible exception of dogs and cats living together).

The other side of the argument was presented by Jonathan Tepper in an "Outside the Box" guest column in John Mauldin's e-letter. He cites UC-Berkeley Professor of International Business Andrew K. Rose, who has done a study of 130 countries spanning 1946-2005 which exited currency areas or saw currency unions break up. His conclusion (cited by Tepper):

"I find that countries leaving currency unions tend to be larger, richer, and more democratic; they also tend to experience somewhat higher inflation. Most strikingly, there is remarkably little macroeconomic volatility around the time of currency union dissolutions, and only a poor linkage between monetary and political independence."

In other words, while the Troika has surely made a bad situation worse by destroying the Greek economy rather than allow default and devaluation (which would cause the losses to fall more squarely on the rest of Europe), that doesn't mean it needs to keep making it worse. Exiting the union would not necessarily be a disaster, if properly prepared for. Then again, if the authorities can't prepare for the PSI deal by quickly producing enthusiastic tenders, it isn't necessarily unreasonable to think they'll botch this.

The difference between the two perspectives, besides the predicted outcome, is that one is based on data and historical analysis while the other seems to draw heavily on the Book of Revelation. The IIF memo also made simple logical errors, such as attributing the costs that Portugal will have to bear if Greece defaults to the Greek default; this only makes sense if a Greek non-default will make Portugal all better, and that's ridiculous. For example, from the article cited above:

"If, by way of illustration, it is assumed that Portugal is unable to access markets through 2016, then official lenders would be required to:

  • Provide €16 billion annually in financing to the government from 2013 through 2016, or €65 billion in total
  • Help assure that €77 billion of term funding is available through 2016, or about €15 billion a year from 2012 through 2016, together with the refinancing for some €86 billion in short-term credit to fulfill the obligations of Portuguese banks and corporates to foreign lenders
  • Help assure financing sufficient to manage some €330 billion in debt owed by Portuguese corporates and households to domestic banks, 7 percent of which are nonperforming, and some €220 billion owed by Portuguese banks and corporate to foreign lenders. (Relative to GDP, these exposures amount to 194 percent and 129 percent, respectively.)"

Well, actually, no. If Portugal is unable to access the markets through 2016, official lenders won't be required to do anything. If they do not, Portugal will be forced to run a balanced budget, banks will default, and a number of corporate entities will fail. That's not unlikely to happen anyway, regardless of whether Greece defaults this month, so the question in my mind is mostly just about the order of defaults and the timing of Euro exit.

So this is what we will deal with this week, along with tomorrow's Super Tuesday slate of primaries. Equities are not handling the stress extremely well, although they managed to rally and close with only an -0.4% loss on the day. Stocks also had to deal with the statement by China's premier, Wen Jiabao, who announced that the government had set a GDP target for this year of only 7.5% (the first time since 2004 that it hasn't been at least 8%). I don't think that was the main consideration of those lightening up on equities, because Treasuries also sold off (with the 10-year note back to 2.01%, up 4bps). It may have been the main reason that industrial metals dropped 1.6%. However, whether China says they'll grow at 7% or 12%, the more important factor here is (a) does Greece defer default for a little longer, or default and exit rapidly, and (b) which side of the argument above between Tepper and the IIF is correct.

In any event, a safe stance is warranted. And keep in mind that for most investors, it isn't Thursday that matters: long before there is an announcement that the PSI has succeeded (or more likely, that CACs will be invoked or the deal fails altogether), the market will be trading the information because some people will know well before you and I will.

 


[1] By which I mean complex forms of life, not people with more than one cell phone. Although, come to think of it, these may be mutually exclusive.

 


 

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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