EVENT ANALYSIS: Thoughts on the Eurozone “Breakthrough”
Futures are soaring overnight on news out of Europe that discussions have led to a “breakthrough” leading to “long-term union” (the USA Today reports):
“BRUSSELS (AP) – European leaders have agreed to use the continent’s permanent bailout fund to recapitalize struggling banks, and agreed to the idea of a tighter union in the long term.
The bank decision at overnight meetings in Brussels on Friday was aimed at helping Spain, which sought a €100 billion rescue to help its troubled banks and is facing rising borrowing costs.
EU President Herman Van Rompuy called it a “breakthrough that banks can be recapitalized directly.”
He said leaders of the 17-nation eurozone also agreed to a joint banking supervisory body.
He said the leaders of the full 27-member European Union agreed to a general long-term plan for a tighter budgetary and political union.”
Details are few at this point, but the bank recapitalization is a step in the right direction. It is beginning to feel very much like early 2009 as we piece together solutions (and hopefully avoid the worst case scenario involving Lehman 2.0). The bank recapitalization substantially reduces the risk of a broad credit crisis, but unfortunately does not help resolve the core issue, which remains the unworkable currency arrangement. So, we’re making baby steps in the right direction, but there’s much work to be done here. The endgame is still eliminating the solvency crisis at the sovereign level and that has to be done with some form of supranational entity or debt sharing arrangement. The good news out of these headlines is that it seems clear that full collapse of the Eurozone is rhetoric that is becoming increasingly scarce.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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36 Comments
Thanks for the quick recap, appreciate it.
Cullen, What move do you anticipate in the markets as they digest this news? Futures are already higher and worldwide indices seem to be headed +2%
How are you playing this move? Seems to be a pure “risk on” trade to me at this point…
I don’t really “play” day to day moves in the market, but it’s hard to see how most of the rhetoric here isn’t positive. I think the worst case scenario is being removed and they’re slowly inching towards some sort of sustainable solution. There’s more work to be done though so I would by no means say this is the end of the Euro crisis.
“Slowly inching” indeed… I guess anything is better than nothing
Further initial thoughts… if they make it so that Euro banks can get bailed out direct from the EFSF/ESM without their government involved, this could be “risk on”:
message to Euro banks: we plan to bail out any under-capitalised bank – we won’t let you go down due to our irrational fears of contagion. Therefore, GO NUTS! if you screw up someone will write you a cheque!
(I respect that its this potential outcome for the need for a Euro banking regulator, but seriously they aren’t going to be able to stop banks from punting exotic crazy stuff if they choose to do so)
I think the key announcement is if/when they announce the ESM has a banking license and can leverage via the ECB. That’s the sort of announcement that they could quite likely make and never really even need to use the leverage. The threat of ECB backing the ESM ( a mega LTRO in the offing) would take a lot of the nastiness out of the sovereign bond markets itself.
CR says: “I think the worst case scenario is being removed and they’re slowly inching towards some sort of sustainable solution”
IF and When the details of “Bank Supervision” are forthcomming?
The “agreement” is nothing more than end-run around the ESM requirements for aid to sovreign’s–NO STRINGS attached !!!
Given “No Strings” this “agreement” brings the worst case scenario CLOSER
The Germans,Dans,Fins,Belgium,Austria and the Netherlands should Reject outright
How much do you want to bet Soros did a synthetic straddle here? Short Euro forwards, long DAX futures? It seemed pretty clear Friday was the trade inflection point one direction or the other. Why not just play the vol, rather than take a directional bet…
With regard to Soros position: rumors his fund is long 1.5 bln 10 yr equivalent Italian BTPs.
Not really rumors and it’s not the only one. I bought A LOT of BTPs last week and guess it, it was a good decision. One of the easiest contrarian calls of the last years.
This, too, shall pass.
Indeed. How many times have we seen this before?
I see three parts to a deflationary trend in the PIIGS:
1) Undercapitalized banks have to cut lending.
2) High government deficits and debt lead to high interest rates on government debt and to austerity.
3) The private sector is overpriced and uncompetitive.
Only #1 is the same as in the US’ 2007-2009 crisis (and boy, it was a doozy here). Fixing the banks’ undercapitalization is great, and it’s a big component to the PIIGS growing their way out of this. But these countries still need to deflate, which probably means more recessions are on their way. Which means more defaults and bad debt, should the banks lend after recapitalization.
But a more immediate problem is the still-growing government debt in Spain and Italy. How long will it be until we see the European bond vigilantes return?
The combination of #2 (an overleveraged gov’t) and #3 (an underproductive private sector) is really nasty. To become more productive, the private sector has to deflate, which decreases GDP. This increases government debt as % of GDP, and decreases tax receipts, so that the debt is less sustainable. The bond vigilantes raise interest rates, which takes even more money out of the economy. Without outside help, this deflationary cycle ultimately ends in defaults, as in Greece.
So in rebalancing, the GDPs of the PIIGS have to decrease. And gov’t debt has to decrease even faster, since debt/GDP has to decrease *while* GDP is also decreasing. This is currently heading the wrong direction; for both Spain and Italy, debt and debt/GDP are still growing.
Of course, the alternative is inflation. A “soft inflate” version might be that the ECB keeps buying Spanish and Italian debt, reducing the amount of money which exits the countries in the form of interest. However, it’s worth noting that the interest rates aren’t just a way in which money leaves a country, interest rates are also a measure of investor confidence in the economy. Even if the ECB buys debt, lending and growth can still be restricted, if:
(a) banks are undercapitalized
(b) investors think growth opportunities are limited (i.e., more deleveraging is needed or expected)
(c) corollary to (b), capital leaves the country as cash flight.
I think it’s plain that we’re seeing these in Spain and Italy. This strategy might work, but if so, we haven’t turned the corner yet.
This leaves the bazooka: devalue the currency. Drop the target interest rate; ease as much as is needed. As the Euro drops, investments in all of the EZ will become more attractive. Nominal GDPs will increase, and the government debt in the PIIGS becomes more serviceable. However, this only works if the PIIGS keep deleveraging relative to Germany/France. Italy and Spain *have* to reduce their real debt, or this would all be for naught. If investors and gov’t's become overconfident and loose, and they forget all about this crisis, then we won’t make any real progress.
In a way, I think the “soft inflate” plan is the best. Cheaper financing for Italy/Spain is basically a bailout, transferring money from the ECB to these countries so that they don’t have to deleverage as quickly. As long as these countries are unstable and uncompetitive, money will flow out of them to Germany/France, causing inflation there. And this leads to a soft devaluation of the Euro.
The problem is that it’s so *slow*. I worry that the Euro inflation + local austerity won’t be large enough, and that debt/GDP in the PIIGS will keep increasing.
If the Euro manages to stay down, that should help quite a bit.
Judging by very broad consensus (futures, asia), it does look like quite powerfull can kicking move. In reality, all these are not even solid plans, it’s just plans to make plans. No increase in fund commitment. Seniority change contingent on quite critical change in regulation. No deposit guarantee. Still necessary to move through approval process in all EU countries.
No addressing of core EU problems, no addressing cyclical recession they are currently in. No chance to put together US-size bailout.
But still, very very nice last day of the quarter. Congratulations to longs!
Cullen Roche: “The good news out of these headlines is that it seems clear that full collapse of the Eurozone is rhetoric that is becoming increasingly scarce.”
Wait and see. Today Monti says that ESM will buy italian bonds without supervision of Italy by the troika, while Merkel says there will be supervision by the troika.
And today the german parliament will very likely halt the legislative procedure concerning ESM.
“And today the german parliament will very likely halt the legislative procedure concerning ESM.”
Of course they didn’t. This was known in advance, because the so called Social Democrats (SPD) and the Green Party in fact provided Monti, Hollande and Rajoy with the means to blackmail Merkel.
A strange sort of blackmailing, however. It was Spain, Italy and France who wanted the growth compact in the 1st place, and it was in Germany the SPD and the Grüne who demanded it, not Merkel.
But at the summit, the three Club Med leaders said they will not sign the Growth Compact if Merkel does not cave in to their demands about socializing the Club Med banks losses by subsidizing them directly with German taxpayer’s money. Talk about logic, anybody?
And as for the German vote about the enablement act ESM(has anybody actuall read this contract? Sheer madness!), the leader of the SPD correctly stated that what Merkel has agreed upon the night before is in many respects the very opposite of what the parliament is now supposed to vote for. Then he order the jerks, sorry, SPD representatives to vote for this opposite. More or less the same with the FDP.
The German parliament is apparently a schizo convention.
Good news everyone. Europe is saved.
Sorry, Cullen, I couldn’t resist
In the EZ, I don’t see it as 2009 at all. The US in 2009:
- one government; one central banker
- TBTF banks all under one supervisory body
- a high productivity country; better demographics & immigration friendly; highly flexible workforce
Sell into it.
Good idea
!
HHmmm – seems like a lovely premise to agree to set up a funding mechanisim . . . uh, just wondering though, who funds it and with what money?
Jus’ sayin’!!
A bull market start after 3 years S&P doubled? Never heard about it.
With the manipulation of markets, it’s going to be awesome to see U.S. market at all time highs as it is in recession in 2013. WHo cares about corporate profits when everything in the globe is backstopped and stuffed inside the Fed/ESM levered by ECB
Stieglitz, on the BBC, not particularly impressed.
Who cares ? We have to find the way to make some money minimizing risks. The best way I know is a contrarian call when the sentiment is overly negative or positive on something really big and liquid. So the italian bond market was hugely oversold and super liquid. A little easy money. Next week I will see. Do you know some better stategy ? Let me know, in a ZIRP age I’m really short of any ideas.
Charles – if it’s rigged and guaranteed to go higher, it should make your job much easier, no?
Stand in line as they hand out free money!
Sorry, I can contribute historical perspective and am learning some economics here – but unlike BF, I am just a kibbitzer aa far as trading is concerned.
Entirely agree with you “brent” on your comment above.
The key bullish message would have been a clear scheme linking the ESM to the ECB. So far still nothing on that front. No banking licence to the ESM, no willingness from the ECB/Buba to draw a line in the sand regarding peripheral sov bonds yields.
So we got a good step for sure, but as Cullen said “a baby step”.
Wrearing my hat of derivatives markets professional, I think options are the way to go follwing the sharp corrections in implied vols since the greek elections.
Whatever your view (bullish/bearish), whatever the index you look at (Europe, SPX, Nikkei, EEM), vols are back to reasonable absolute levels allowing for interesting risk/rewards.
Also true for the fx universe.
Another thought : on a relative value basis I do believe a long European markets / short EEM look interesting on current levels.
European large caps are under-valued and more importantly massively under-owned. Even a small reallocation from large international institutional investors could fuel a decent rallye.
At the same time the crowded EEM trade seems to rely on incresingly shaky foundations. These last few weeks the newsflow from India, Brazil, China… has been poor to say the list both from a macro prospective (PMI indices, faltering growth in India and Brazil etc…) than from a micro prospective (numerous warnings and/or cautious messages from multinationals mentionning a slowing of activity there, Nike, Bmw, Siemens…). Still the EEM Index trades not that far from its highs. In case everything unravels again it seems to me there is much more downside in EEM relative to Eurostoxx.
MONEY PRINTING = INFLATION
Not always. Money is often printed and buried in the ground essentially.
Last ECB press conference, Mario Draghi: “markets are underestimating the political commitment on the Euro”. I think that finally we started moving in the right direction, of course it will not be a fast and easy process but all skepticism about it bodes well for a risky assets rally with outperformance of Southern Europe markets. The kind of comments I’m reading reminds me of summer 2009.
Yadda yadda yadda, more of the same.
This remove systemic risk from the equation (for now). Who really believed they would let their own system to failure cascade and end with them hanging from light polls? Very stupid call.
But then we will see how German courts react (some places still have a semi-functional non-crook legal system). Internal politics at eurocore are important.
The obvious elephant here still is fiscal unsustainability until the ECB is allowed to freely act in the market (big bazooka moment). This still is NOT on the table yet (instead we have more complex schemes for refinancing unpayable debt which will have to be either monetized or written down). The other related elephant is no-growth environment and private unsustainable debt levels.
So we will see how far we get and how long are the legs for this rallies. I want confirmation beyond short squeeze in the following markets:
SHORT TERM BULL: european periphery yields, corporate risk/financial CDS, gold & silver.
I still have long IBEX positions (Spanish stocks) to sell high if this fades.
LONG TERM BULL: higher bund and UST yields, inflation + real growth, higher deficits + private deleverage, positive equity of households (real estate prices), last but not least higher incomes + employment growth.
“Long term bull” without growth looks ambitious…
If and when the focus on Europe eases a bit the real story will be growth, and the lack of it. Anywhere you look at…
An important point that needs to be remembered about the EU is that it is losing workers like never before and it’s unstoppable unless there is a major immigration push – unlikely. According to the EU itself, “from 2015, deaths are projected to outnumber births in the EU27″. Long term bullish?
Almost three times as many people aged 80 or more in 2060
The EU27 population is projected to increase from 495 million on 1 January 2008 to 521 million in 2035, and
thereafter gradually decline to 506 million in 2060. The annual number of births is projected to fall over the period
2008-2060, while at the same time the annual number of deaths is projected to continue rising. From 2015 onwards
deaths would outnumber births, and hence population growth due to natural increase would cease. From this point
onwards, positive net migration would be the only population growth factor. However, from 2035 this positive net
migration would no longer counterbalance the negative natural change, and the population is projected to begin to
fall.
The EU27 population is also projected to continue to grow older, with the share of the population aged 65 years
and over rising from 17.1% in 2008 to 30.0% in 2060, and those aged 80 and over rising from 4.4% to 12.1% over
the same period.
http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/3-26082008-AP/EN/3-26082008-AP-EN.PDF