3 SMART BEARS
Pretty interesting quote from this week’s Barrons and Michael Santoli’s weekly piece:
“Plenty of folks who have gotten things mostly right in this cycle are tactically nervous. The Leuthold Group has said the cyclical bull market might have seen its peak. The Ned Davis Research ‘cycle composite,’ blending historical one-, four- and 10-year patterns, has turned negative. Michael Darda of MKM Partners, an economic optimist until earlier this year, fears that sluggish European monetary policy making is dooming the Continent to recession and contagion. Bridgewater Associates, the huge hedge-fund firm, stated in a starkly concise commentary Thursday that ‘there is an uncomfortably high probability that there will be an unmanaged banking and sovereign-debt crisis in Europe.’ “
Leuthold and Darda were notable bears before the crisis and both turned bullish near the bottom. Bridgewater, of course, is the world’s largest hedge fund and continues to navigate this environment beautifully. I largely agree with the commentary above. Although I don’t pretend to be able to predict what part of the market cycle we’re in I do agree with the notion that the risks in Europe have set the table for what certainly has the potential to end disastrously. The European leaders are so far behind the curve on this one that it’s now looking like catastrophe is the only thing that will get them up to speed….
Which means keep some dry powder ready so that when it happens, Swoop in and pick the ripe fruits.
Thanks for quotes and commentary TPC..
Cullen,
I am a little confused over the European situation at the moment. Let me explain: the ECB is finally buying the junk bonds of the euro zone to keep rates low. I am assuming that any pull back from the ECB at this point would push back the rates exactly where they were if not higher. I understand that the ECB is intervening “temporarily” and wants the EFSF (which is a fund with taxpayer money from AAA Euro countries, unlike the ECB who prints) to take over to the job.
Why is the ECB so reluctant in the first place to buy those bonds? I read Trichet is scared to devalue the euro (I am not sure that is true, even though a weak euro could help indebted EU members) and encourage fiscal indiscipline in terms of following austerity measures.
Also, the process of increasing the EFSF fund seems to be a very long process because the Germans would have to be the biggest contributors and therefore stepping on the breaks. With a possible downgrade of France coming in the near future, I see the ECB buying those junk bonds for ever.
What is your take on this?
Again thank you for your blog.
Regards.
The ECB is absolutely loathe to embrace QE (it’s a philosophical thing). Consequently, it must rely on the EFSF which is increasingly becoming an obligation of Germany and Germany alone. If it stays this way, popular revolt will force Germany to abandon the EMU and the rest of the eurozone will fall apart.
So it’s euro QE or bust here. I don’t believe eurocrats will choose bust first, so I therefore expect an argument and eventual acceptance of E-QE, leading to a falling euro which actually benefits Germany.
A lingering German fear is that QE is not conducted prudently, because when a basket-case economy like Greece is in the mix, easy swaps lead to excessive inflation. The ECB must not swap readily for junk, there *must* be consequences for poor economic management.
Is the ECB then likely to keep purchasing those bonds until real decision to use QE is made? That is the question. The EFSF will never reach the 2T needed, it’s just too much to ask from the Germans. The stability of financial markets depend on it. Being from Europe, I know how long things take over there. This could take more than a year.
Exactly right. The longer Euro QE is stalled, the worse things get. I’ve lived in Europe (Germany) so I know exactly what you mean when you say things take time
Administration is a bearish factor for Europe. I think people underestimate how long it takes to get things sorted out when the participants literally don’t speak the same language.
The unification process seems extraordinarly difficult. Would countries need to limit nationalism, have common taxation and retirement policies, etc.? What enforcement mechanisms would be needed? When and how would all of this be resolved?
European banks have reportedly “reduced their exposure” to PIIGS, not by selling off their holdings of PIIGS debt but by simply buying CDS against it. This is not a reduction of risk within Europe, it’s just a game of pass the bomb and a transfer of the currency denomination of risk. The sellers of CDS here are likely following improper risk models and it will blow up in their faces just as it did for AIG. Credit events in Europe will create urgent shortages of eurodollars (a run on the eurodollar system). In response, exposed agents have several options available but will likely end up drawing eurodollars from the ECB which may provide them following currency swaps with the Fed (extension of the previous swap agreement has no upper limit I believe). If the ECB fails to move quickly enough, the Fed has the option of direct asset swaps with primary dealers (as in QE2) to ease pressure on eurodollars.
Returning to CDS, the refusal of the ISDA to declare Greece’s recent default as a default was, in my opinion, indicative of the corruption of the ISDA (its members represent the very same interests most exposed to CDS triggering on Greece). The message this sends to the market is that those agents who believed themselves to be covered by CDS are NOT COVERED. End result? A selloff of PIIGS debt to reduce exposure seeing as the supposed security provided by CDS is a mirage. Falling prices therefore push Greece even further into the next default.
Defaults cannot be avoided regardless of whether the ISDA wants to play games or not. A loss is a loss and somebody must end up paying for it. The current state of the crisis in Europe and the extent to which it deteriorates depends very much on the ability / willingness of the ECB to embrace QE denominated in both USD and EUR. In the case of USD denominated component of QE, the Fed can ensure that it is resolvable, even if the ECB won’t (although the numbers involved will blow a few minds and get the inflationistas fired up again).
Euro denominated QE is a different story and requires a philosophical shift at the highest levels of the ECB. Failure here guarantees a major crisis. The ECB must clone the Fed’s QE1, only instead of taking toxic ABS onto its books, the ECB will be taking toxic sovereign debt. In both cases, the CB overpays and then marks the asset to fantasy giving the illusion that money has not been printed. Were these assets to be honesty marked to market and the CB wrote off the loss (as it can easily do with the benefit of an infinite cash asset), then it would be clear that money had been created, justifying a fall in currency valuation.
So focusing on the euro component, watch the politics and rhetoric regarding the ECBs purchasing of (bad) eurozone sovereign debt. If the ECB is hamstrung by Germany then equities tank. The Fed can help ease a run on eurodollars but it can’t do much about a run on euros. Conversely, if the ECB does do what is needed, keeping equities buoyant, then the euro rightfully tanks.
Hey Mediocritas,
Thanks for your comments. Can you clarify for the rest of us what exactly eurodollars are and why they are so important?
Good question, the euro and eurodollars threw me a curve also.
Nice write up Med..
Eurodollars are dollars in accounts outside of America. It doesn’t have to refer to European accounts specifically anymore, but in this instance it does.
@Mediocritas
If only forex markets were concerned about “valuations”.
Exactly opposite. Euro would remain austere enough to grow.
Accidently seems to be pegged to dollar recent weeks.
Agree mith Med than the euro should theoretically fall if ECB embarks on QE (which I also believe is the only way out). Still you can notice that each time positive rumour start swirling around ECB bond buying the euro rallye as market feels (temporarily) relieved.
My take is therefore this : in case of a clear QE approach, equities should rallye in tandem with euro on short covering from players shorting the currency as a way to “play” the eurozone debacle.
This could offer a great shorting opportunity on the euro as once the market will have settled it should effectively subsequently focus on the debasement/printing issue.
Of course we’re far from here and I honestly would not be able to assign a probability to the event “QE or not QE” from the ECB at this stage as so many political and psychological factors have conflicting influences.
Sormiou from France
Quite right, Europe is so much more complex than the USA and any short-term relief rally in the Euro on signs that the EU is sorting things out provides a good opportunity to make a short entry. The Fed/ECB swap agreement provides some relief for the euro, preventing forex markets from having to provide dollars for euros, so I’m keeping an eye on swap operations. Zero open at last check.
I’m expecting to see a strongish euro as this crisis continues to not be dealt with as the developing run on european banks creates heavy demand for euros. Possibly a short term move up when euro-QE is announced, then the ride down begins. Right now I’m mostly in cash, looking for good technical entry points.
Cullen, Randall Wray has a great new paper up at Levy on the causes of the GFC. Excellent summary founded on the principles of Galbraith and Minsky. You might want to post it up. Makes for good weekend reading.
http://www.levyinstitute.org/publications/?docid=1402
Great paper. I love Minsky and glad it is making inroads into MMT. Some comments.
1. He concludes interest rate increase did not stop the housing bubble, but in general (and as probably as he is aware) this is not the case for all bubbles. If margins requirement are increased or interest rates are raised as was the case in the 80s for gold, than the asset can fall. Nonetheless I agree interest was not the only and probably not the primary reason.
2. The point that “Unregulated and Unsupervised Financial Institutions Naturally Evolve into Control Frauds” – I would generalize control fraud to cover the Fed, Treasury and Government controlled by lobbied interest who control monetary and fiscal policy and are prone to “control fraud”
3. He points to leverage particularly private being a more important factor (that which I agree with) and the fact that now with government debt included we are at the same level of overall leverage. The requirement of leverage exist for a crisis.
BTW the Hyman Minsky Instability Hypothesis gives a good model of the 2003 Japan debt “crash”. Japanese Government Bonds (JGB) are considered risk free assets and used by banks, institutions and individuals as collateral in their investment accounts accounts or assets on their balance sheets against liabilities (of which a large portion was bad debts not written down by the zombie banks).
The process would proceed something like this
1. Investor/Institutions profitably use JGB (or treasury) as collateral. And banks used them as a balance sheet asset but have systemic risk (bad debts)
2. The success breeds further demand and the JGB is bid up in price (yields decline) as they become known as stable and risk free collateral
3. An exogenous (Greenspan lowering rates 0.25% instead of the expected 0.5% in 2003) created a selling panic spike in JGB yields. The JGB yields rose by 1% to a yield of 1.4% in a matter of 3 weeks. Vigilantes joined the sell off as risk management banks and institutions were forced to sell off these underperforming bonds. This created further down pressure on price and boosted yield over the three weeks. An investor that could withstand this drawdown would be unaffected.
Fortunately for Japan this sell off did not spill over too destructively to the stock market, but the mechanism can be understood how “leverage” and “bad structural debt” combined with exogenous event (Fed statement etc) can create bond crash even in fiat currency where the central bank has large but not total influence of the market yield. Also, it should be noted that yields in Japan were artificially set low by the central bank, so the corresponding yield spike maybe even higher (Japan whose yields rose 1% compared to 0.5% in US).
I hope we don’t follow the Japanese experience. And hope this is consistent with MMT thinking that bonds are default risk free but not “risk free” in general.
Mediocratis,
Brilliant thoughts and I agree with pretty much everything you have said. I think there may be other potential options but the real result will be the same Euro QE.
So, other than simply shorting the euro, is their any way to get long gold in euros.
As I see it, they either devalue it or it blows up, which should make gold a moon shot no?
I think so yes, but with some caution.
If Europe blows up, we’re going to have to see EU-QE and US-QE simultaneously. Hard to say which currency will fall more but I’m guessing there will be greater demand for dollars than euros so the euro may fall further. However, as you point out, it makes much more sense to take a position against which both currencies will fall (eg, gold).
Two things make me a bit nervous about gold as a long right now (I actually sold all my PM miners). First is that in a big European blowup, the initial phase will see a strong demand for both euros and dollars, coincident with a selloff in PMs as CDS exposed agents rush to find cash (as we saw in 2008). If that happens, with QE to follow, back up the truck and buy PMs when they’re cheap. Because I see big trouble in Europe, I’m therefore keeping my powder dry for a better PM buying opportunity. I’ll regret it is Europe doesn’t blow up and we slide smoothly into QE, but I’m not comfortable with the risk.
Secondly, the CME has demonstrated great willingness to hike margins unexpectedly on PMs. There’s something fishy about that and I’m not too happy being on the wrong side of it.
But yeah, if the PMs tank, that beeping sound you hear will be me backing up the truck. I bought a lot of silver between $12 and $13 and I’d love to get that chance again!
I do think that the PMs may have a pullback here, and I think that some form of eurobond will be implemented. They have already been buying bonds so I think where this is going is a QE type.
I will be very interested to see what BB says in Jackson Hole, American banks have exposure to Italy that is troublesome.
I am waiting for gold to have its pullback and thinking about buying some very long dated GLD options OTM and seeing what happens…
Good idea. One thing that seems pretty much guaranteed is that we get continued volatility, even if we can’t accurately predict direction. So setting up long strangles makes a lot of sense to me regarding the PMs and financials.
Regarding US banks and Italy, is this the reason they are not participating in this rally the last few day? People don’t know how much risk they have hidden under the surface, no?
Word is that the Fed examined major banks balance sheets and exposure to Euro banks. They were ok with Greece, Ireland, Portugal and Spain exposure, but apparently were very concerned about exposure to Italy.
that is a problem apparently.
France and Germany ruling out Euro bonds:
http://www.ft.com/intl/cms/s/0/d4ddaa06-c68f-11e0-bb50-00144feabdc0.html#axzz1V2eSR3Ut
stubborn bastards, huh?
That’s Europe!
Meanwhile, the run on Societe Generale isn’t going to politely wait for eurocrats to agree on things…