Diary of a Financier

Europe Awoken to a New Week

In Economics on Sun 7 Aug 2011 at 23:43

Before I fall asleep tonight, I wanted to chime-in on the recent developments in Europe. I’ve left the fundamental arguments to the rest of the blogosphere. I’m reading a lot of brilliant, eloquent analyses from so many sources, but much of it is baseless speculation or tired reiteration. Markets are sliding so quickly that a 10% rally in PIIGS bonds is conceivable for a week’s work. That would change the landscape entirely; new momentum; new trends; new fundamental valuations. Fundamentals are not static, they are dynamic, and many commentators seem to forget that. Long-term, markets succumb to their fundamental values, but the short-term can be a widow-maker for traders.

For example, the ECB closed the weekend with an announcement… essentially, they will buy bonds from Italy and Spain (a “bailout”) to promote stability in the region. It’s a woefully paltry pact by the numbers, but guys like me–who are counting [15%] paper gains on their shorts–might just decide to call their profits. (After all, I’m not looking to turn the screws on Italy, I’m just undertaking a short position as a sound hedge.) It doesn’t take much to send the real vigilantes running for the hills. Those players are operating under serious leverage/liquidity risks, so they have to tread lightly. An insufficient pact like this ECB bond-buying concession can launch a reflexive counteroffensive–despite its toothlessness. That’s pretty much how Europe diverted the spotlight from itself in 2010, when the stakes were just as high as they are today.

I can baselessly hypothesize with the best of ’em: Germany & France are the payors, so they’ll swoon at the start of this week, while the payees Italy & Spain can levitate. I prefer to stick with what I know. Aside from the technicals–which adequately communicate the psychology behind market fluctuations around fundamental values–here’s a few things I know about Europe’a conundrum…

1. The Eurozone is far from the political/fiscal union needed to save it from dissolution- Our Group is so convinced the EMU will collapse that we’re trying to affirm the contrary before committing more capital to the macro “Euro bust” trade. Right now, we’re participating in the downside of Italian equities for defensive purposes, but soon we could take the offensive. My partner called me late Friday night to mention, ‘the European Union has a greater GDP than the US, so how could they not coordinate a bailout of TARP’s proportions?’ First, the EU contains 27 memberstates, including those who aren’t part of the 17 member monetary union. For GDP aggregates, make sure to distinguish between the two. Why would non-EMU states agree to fund a PIIGS bailout that’s really aimed at saving the currency bloc? Second, remember that the US has an autonomous, self-funding federal government to serve as a lender-of-last-resort. Washington DC collects its own revenues (mostly from taxes) in far greater excess–on both a gross and percentage basis–than its subordinated state & local governments. An appendage theoretically chained to the US Treasury, our Federal Reserve can thus implement monetary measures to affect the coffers of the federal government. Juxtapose that with the ECB, which is not backed by either the credit of a supranational Treasury, nor the specific revenues. The ECB is rather an off-balancesheet SIV, for which the ownership rights are shared by its memberstates. The ECB isn’t even a capitalized vehicle. In fact, its 5 billion euro capitalization is held by the national central banks of its members. If California needs a bailout, the US Federal government can summon its own means–irrespective of the participation/interests of other states–to quickly act on the matter. The ECB needs approval from its Governing Council, composed of representatives from every memberstate. Aside from the bureaucracy, the ECB needs equally proportionate participation–like the Fed asking Wyoming to fund the same [proportional GDP] contribution to a California bailout as New York. I mean, Wyoming probably has little interest in the Californian economy, while New York might hold a lot of Californian debt and trade interests. If it were faced with this ultimatum as a member of the EMU, Wyoming would likely defect from the currency union for a new status as a plain, vanilla Eurozone member with its own currency. Why exacerbate its own economic struggles to save an irrelevant neighbor?

2. Germany was one of four Governing Council voters to object to the renewed bailout- I expected Germany to sit idly as the fringe states fell, saving its resources to bolster the core members like France, if necessary. Now that Germany is being activated so soon, Tyler Durden made a great observation:

[M]erely a €1.5 trillion expansion in the EFSF, would mean that Germany is on the hook to the tune of €790 billion or 32% of German GDP. If France is downgraded, Germany essentially becomes the sole backstopper of the entire Eurozone, to the tune of €1.4 trillion or 56% of its GDP. Now let’s assume… the full amount under the EFSF has to increase to €3.5 trillion. That means that Germany “contin[g]ent liabilities”, in the worst case scenario where France again gets downgraded, and it likely will eventually, would surge to about €3.3 trillion, or an insane 133% of German GDP!

3. Europe is a game of dominoes- Greece had an insolvency problem, and it will unequivocally collapse in the near future. Italy is not [yet] insolvent, but it is struggling with liquidity.  Italy boasts some solid economic data like a budget surplus, but anemic growth compound by large public debt means it needs access to capital markets to keep it running.  EU capital markets are seizing like a slow-motion version of the Lehman liquidity crunch:

EURIBOR (Overnight)

EURIBOR (1-week)

Like I said, a 10% bond rally in one week would do wonders for the situation. But at the same time, Italy holds so much Greek debt that it won’t be able to shake its hangover for very long.  It’s hard to imagine anyone investing in the European periphery–beyond buying to cover shorts or to capture schizophrenic spikes.

…It just makes survival seem all too unlikely, no?  I’ll enter the week having carried short positions through the weekend: short Financials (XLF), short US Small Caps (IWM) & short Italy (EWI).  Due to my analysis, I don’t expect to cover any US shorts right away, but I’ll be interested to watch the trading flow in Europe.  If the market wholly fades Europe’s bailout, I’ll be in awe of the implacable force of vigilantes.




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