The Not-Laid Plans Of Mice And Men

By: Michael Ashton | Wed, May 30, 2012
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The nice aspect about Europe being the only thing that matters these days is that I don't have to wait until the end of the U.S. trading day to begin writing an article. All of the damage is done early in the day, and then we watch the markets trade more or less sideways or sometimes even correct a bit once the sun sets on the Continent.

Wednesday was no different. Earlier in the week, there had been some optimism that Greek voters on June 16th might vote into power a bailout (and austerity)-friendly coalition. With weeks to go before the election, this seems a thin reed on which to base a strong rally, especially since the polls in question are both highly variable and highly suspect, given the perceived extreme importance of the election. Personally, I don't see the election being extremely important - mathematics trumps politics, so no matter who wins the election the outcome won't change. Greece will almost certainly leave the Eurozone, and the only questions are how soon it will happen, and how prepared Euro institutions will be. The answer to that latter question is somewhat frightening, since the headlines last week focused on how this country or that agency or that supranational organization was "discussing contingency plans" in case Greece exits the Euro. It is incredible to me that such a contingency hasn't already been discussed in each of these institutions sometime over the last year, even if a Greek exit was seen as very unlikely. It's prudent to plan! (Then again, I spent hours last night getting home because New Jersey Transit had no plan in place describing what to do if a tree fell on the tracks).

The optimism early in the week faded quickly and markets were more or less in rout mode today. Spanish 10-year yields rose to 6.65% (see Chart, source Bloomberg), near a new crisis high, so we are only days or at most weeks away from that situation coming to a head.

Spanish 10-year yields rises to 6.65%

In Spain, the bailout of Bankia has taken on a drama all of its own. The original estimate of the size of bailout required was, of course, too low. Spain cleverly proposed to inject €19bn of its own government bonds to Bankia, that is would then use as collateral to borrow actual money from the ECB. Spain would count this as an investment, rather than as a debt, so that it would improve the country's balance sheet rather than worsening it. The ECB thought this too clever by half, and by the way far too transparent a violation of the ECB's stricture against "monetary financing of governments," and rejected the plan out of hand.

But that's okay, because this morning some EC functionaries passed around the notion that they were "open" to using the ESM to lend directly to banks. Markets rallied euphorically but briefly on this news, but the rally quickly failed on some little details...such as the fact that the ESM isn't set up yet. Actually, the best discussion of the merits and demerits of this idea was Peter Tchir's article "National Acronym Day in Europe. Don't Underestimate the ECB." Pete explains why there's some desire to use the ESM rather than the EFSF:

"If ESM can be launched, and it can get a banking license, then the EU has a powerful tool. The ESM is allowed to do all the things the EFSF can do - participate in new issues and the secondary market and lend to countries for them to support their banks. Without a banking license its firepower is limited. With a banking license it can leverage itself to a very high degree and can tap all the cheap funding already in place and whatever new programs the ECB decides to launch."

As Pete and others noted, the fact that the ESM isn't set up yet is an important qualification of this idea. The other qualification is the fact that Germany and Finland, whose backing is absolutely required if the ESM is to have any value at all, flatly rejected the idea.

Markets erased all of Tuesday's gains and then some, with the S&P dropping 1.4% on the day. Commodities, which increasingly seem to be suffering from divestment flows (and possibly momentum players on the downside), fell also with the DJ-UBS down 1.3%. That index is -8.4% on the month, even worse than the -6.1% of the S&P. NYMEX Crude was -3.7%, Gasoline -2.2%. In fact the commodities for the most part were down in direct proportion to their liquidity, with the main exceptions being gold and silver. Yes, the dollar is strong versus the Euro, but it is weak versus the yen! The buck is nearly 6% weaker versus the Yen since its highs in March, and 7% stronger against the Euro. Fortunately for commodities bears, Asians don't use commodities...right?

Confounding expectations, including mine (although thank heavens I covered that short-bond trade), nominal and real rates continue to decline. The 10y Treasury yield hit 1.62%, 13bps lower on the day, while the 10y TIPS rate fell to -0.48%. The 30-year real rate is now only 0.55%. While real rates and nominal rates continue to hit record lows, inflation expectations do not. 10-year inflation swaps ended the day around 2.41%, well below the 2.75% of March but still well above the 2.20% of last autumn, the 2% of autumn 2010, and the 1.25% of late 2008 (see Chart, source Bloomberg).

10-Year Inflation Swaps at 2.41%

As silly as it was for the EC to propose using an ESM that isn't even set up yet, I actually think that the idea is targeting the right response in a way. The best (remaining) solution, in my view, involves kicking out the weaker members of the Euro and then bailing out the banking system with the huge amounts of money that will be required. Yes, it will have to be printed because there's just not enough real capital available. But the Euro is untenable in its form, at least now. And any disaster that supposedly follows the exit of one or more members will primarily stem from the carnage it would inflict on a financial system that is loaded to the gills with sovereign debt.¹ Bailing out the financial system - not indiscriminately, mind you, but favoring the stronger albeit not necessarily the larger institutions - won't be popular but is not entirely unfair in this case since the banking problem in Europe was partly caused by dumb regulatory risk weightings that encouraged banks to hold more sovereign debt, partly by ill-considered moral suasion used to persuade banks to hold more sovereign debt, and only partly by poor risk management.

That solution will never happen, because it would require a whole lot of legislatures to authorize some extreme solutions, and such an approach is not politically palatable. What is more likely to happen, because it is constituted of bite-sized political pieces, is closer to the worst case: don't kick out the weaker Euro members, so that the imbalances remain, and bail out banks in serial fashion rather than all at once.

Not that there weren't better solutions, mind you, in the past - but the time for them is gone. We're down to just hard solutions. In this case, the cheapest fix remaining will be liberally applied: cheap money. Yes, I know that the Fed is insisting (as Fisher did today) that more stimulus isn't needed. And they're right, because stimulus doesn't work. But it's still perceived as a cheap lunch, and as the situation in Europe worsens and the bank runs accelerate, central bankers will fire up the technology that fired up Bernanke's imagination back in 2002: the printing press.

Back on the boring side of the Atlantic, tomorrow ADP (Consensus: 150k) and Initial Claims (Consensus: 370k) will be released. There is reason to be wary of these numbers. Last month ADP came in at 119k, which was well less than expectations. History shows that with ADP economists tend to miss in the same direction at least a few times in a row, so another soft print is likely. It's unlikely to show the economy is collapsing, but it will reinforce the sense that the U.S. economy is slowing, and unlikely to be robust enough to pull Europe (and perhaps China) out of the tailspin. This will not hurt the bond market, but if the data is weak...yet not dramatically weak...then equities may get a bounce from the idea that QE3 just got closer.

 


¹Of course many other businesses will suffer losses on cross-border contracts that were poorly constructed, not providing a fallback currency arrangement to the Euro. This violates the girlfriend rule of thumb: Don't make plans that are further in the future than you have been together so far. Greece joined in 2001, so if you wrote a contract in 2007 that went further out than 2013 without a fallback mechanism, shame on you!

 


 

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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