A View from the Trenches, March 1st, 2011: " A strong Euro and an unstable China"
In our last letter, we wrote that we were finding the market action inconsistent and that we wanted to walk to the sidelines. Well, we wanted, but the market didn’t let us, for we had to get back to stocks and gold, given the strength shown, albeit with less leverage. We were wrong about the move, but not on the view, we think.
As we had mentioned, we were and are concerned about the strength of the Euro, which yesterday made it all the way back to 1.38 USD. At “A view from the Trenches“, back in May 2010, we were the first to say that the Euro crisis was not a solvency, but an institutional crisis, and furthermore, that the survival of the Euro would require flexibility. We have no alternative but to reproduce what we published on May 6th, 2010, just before the bailout package was announced. Back then, this was considered a contrarian view! In hindsight, it still looks ominous:
“…There is a line of reasoning that compares the current sovereign events with the credit events of 2008 (i.e. Bear Stearns, Lehman, refer “European Credit Compass”, UBS, April 30, 2010 report). We could not disagree more. Bear and Lehman were investment banks, funding on a very short-term basis, highly leveraged and were big counterparties in many markets.
Sovereigns on the other hand are not counterparties and the troubled assets, the sovereign debt, have the European Central Bank as counterparty! The fact that the Euro is devaluing on a daily basis shows that this counterparty is working fine, for it is monetizing sovereign debt. Monetizing sovereign debt is the same as paying par on leveraged debt. The ECB, as counterparty, honors the contract and when it does, it adds liquidity. Hence, the excess supply of Euros and its consequent drop in price.
In fact, we should be concerned if the Euro appreciated!!! For this would mean that the ECB, as counterparty, would not be there to pay par on the sovereign debt! That’s why we find comical that some Euro politicians like Mr. Axel Weber openly defend a strong Euro. The survival of the Euro as a currency, ironically, lies on its flexibility to be devalued!…”
Having said this, we want to bring collective attention to the fact that Greece’s sovereign credit default swap ended February 110bps wider, with an inverted term structure (5-yr at 946bps). In light of what we just quoted, this makes perfect sense to us. There is a hawkish message coming out of the ECB, pushing the markets to price in an earlier interest rate hike, while liquidity has been drained from the system. In summary, this has lifted the Euro. But what we want to leave the reader with today is that the Eurozone is in fact weaker because of that. The result of this policy will be the inevitable default or restructuring of peripheral debt, which is why gold, unlike in 2010, is rallying with and not in spite of the stronger Euro. Mark our words here: Should the ECB and the EU council support this trend after the meetings on March 3rd and 11th, without the explicit support of the European Financial Stability Facility, we will see a massive run against the financial system in Greece. Maybe not in 2011, but likely in 2012.
The other concern we have these days is the situation in China (no, not in the Middle East, but because of the Middle East). As country after country in the Middle East brings down its dictatorship and we read that China is using repression against dissent, we wonder how long can the status quo remain there. Should inflation pick up, we think the fall of the status quo in China will be inminent. And then? So far, we can only ask questions, acknowledging that sometimes, the questions asked are more valuable than the answers guessed.
If inflation brought China’s dictatorship down, the manipulation of the fixed exchange system as we know, would no longer be feasible. This means that the accumulation of US Treasuries by the People’s Bank of China would be seriously challenged, bringing about a revaluation of the Yuan. Would that be recessive for China? And if so, would it not impact the real estate bubble in that nation? Would it lift or bring down the price of commodities? Would it be chaotic enough to push gold to obscene highs? Or would the international community have enough foresight to work an orderly exit? Would the existing onshore/offshore financial structure, with Hong Kong as accomplice be a blessing in stopping the contagion to the rest of the world?
Is it too early to ask these questions? If it is, can there be another catalyst that may trigger a civil uprising?
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