A View from the Trenches, June 17th, 2010: " It doesn't make sense"
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We have been at a loss trying to understand the markets since last Thursday, when the Euro began its rally. The chart below (source: Bloomberg) shows however that so far, the Euro has not “yet?” been able to break through and close above its 30-day moving average of 1.2327USD. We can see why, and certainly hope the market does see that too.
On Tuesday it became official that Spanish banks are surviving thanks to a lifeline from the ECB, which is earning its reputation as lender of last resort. After Greece’s risk rating downgrade by Moody’s on Monday, the ECB is applying a 5% discount on their sovereign debt, when submitted as collateral. In the case of Spain, the news in our view could not have been worse: Spanish banks in May had the access closed to the capital markets, and borrowed EUR85.6BN from the ECB, which apparently is almost twice the size of liquidity needs at the time of Lehman’s collapse in 2008. How the Euro could have rallied on such news is also impressive, and makes us think that the short covering has been brutal.
The other chart at the bottom (source: Bloomberg) shows the spread between Spain’s and Germany’s sovereign risk. It continues to increase. It’s been a volatile path, but a sure path nonetheless.
We have come across some research that suggests the intervention of the Swiss National Bank, although significant vs. the Swiss Franc, could not have sustained the recent rally in the Euro on its own, to the +1.23USD level. Perhaps it triggered the chain reaction, which involved equities, but it could not have sustained it. Along the same line of reasoning, it seems to us that the situation with British Petroleum also triggered the current rally in oil and Canadian oil sands equity plays, which is more evident after yesterday’s bearish inventory data, released by the Department of Energy.
Fiscal data out of the US is also not encouraging (after all, we are at the beginning of a major, major sovereign risk crisis), but that is a matter for another time. When will we see a return to the downward trend in the S&P 500 200-day moving average?
Finally, we want to discuss an idea suggested yesterday by Morgan Stanley’s Global Economics Team (ref.: “The Lure of Liquidity”, The Global Monetary Analyst, Morgan Stanley, June 16th, 2010). The authors (i.e. J. Fels and E. Bartsch) propose that “…the Euro has been caught in a vicious circle, where the sovereign debt crisis and the bank funding crisis are mutually reinforcing each other…”. Essentially, monetary policy, which this report calls “Passive quantitative easing” is to blame for this spiraling circle. It is also proposed that had the ECB activated “Active quantitative easing”, where the central banks buy public or private (i.e. mortgages) bonds in size, the result would have been different…the crisis would have been contained.
We could not disagree more with this flawed and misleading notion. It is flawed because it doesn’t acknowledge the structural difference in what the ECB is financing, vs. what the Fed was financing. We brought up this issue weeks ago, when we said the Fed had been financing “stocks” (a magnitude in Economics), assets, which are finite and certain, like mortgages, while the ECB is financing “flows”, which are only determined at the end of a period (i.e. Q4 2010) and are therefore uncertain. Thus, the ECB cannot commit to buy a certain size of debt and run the risk of failing to meet expectations. The ECB, as well, cannot have an exit strategy, as we discussed in our letters at the beginning of May.
This interpretation is also misleading, because it suggests that the solution to this problem would have been increasing the capitalization of the European financial system. This system is not active, but passive in this story. The banks did not “decide” to buy government bonds. They, as the case of Greece very much illustrates, were forced to buy these bonds (something we also singled out as far back as December 17th, 2009…remember the initial private placement of EUR2BN with the National Bank of Greece et al., when the problem first came up), as much as Basel III, pro-forma, will force other banks to dump corporate credit in favor of sovereign credit. The Euro problem is institutional, is a problem inherent to the structure of the Union in itself (i.e. lack of a unified bond market) and the only way to deactivate it now is by showing net consolidated fiscal surpluses with clear transfers from the rich members to the profligate members. Politically, it’s a tough sell.
Martin Sibileau
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