Monday, May 31, 2010
The ECB Bond Desk Flees as the EU/IMF Rescue Package bursts into flame.
Apologies for the hiatus but I have been like a deer in the headlights these past few weeks. Events have occurred in the markets and in Dubai which have absorbed my time and attention and come more swiftly than I have been able to write about them. Thus this will be a limited post about what I think is the most important thing going on in the world right now.
It seems to me that we are in the middle of an extended speculative attack on the Eurozone. I have described the mechanics of this attack in an earlier post. The initial weak point was Greece and the markets have effectively shut Greece out of the capital markets and triggered the bailout by the IMF and the EU. This obviates the need for Greece to access the capital markets for at least two years which is good news but the stresses on Greece remain. The five year CDS on Greece still indicates that the markets have severe doubts about the ability of Greece to successfully implement its austerity package without damaging the economy so much that it cannot recover.
More seriously the obvious reluctance of the EU to help Greece and the riots in Athens that accompanied the vote on the austerity package necessary to secure the aid and avoid default massively undermined market confidence in the Euro and the panic quickly spread from Greece to the Iberian peninsula. This necessitated the “nuclear option” of a much bigger package to reassure the markets that the Eurozone would not come apart. The Europeans produced this package but it has come under attack almost immediately.
I think at this point it might be helpful for me to define what I mean by "shut out of the capital markets" and a "speculative attack." By "shut out of the capital markets" I mean that when a combination of CDS demand and a reluctance on the part of investors to buy newly issued debt of a country either chokes off all borrowing or pushes the cost of borrowing up so much that the interest on the debt alone would be more than the country could bear. For example a country whose economy was growing at 3% that was forced to borrow at 15% could never escape the debt trap and so would stop borrowing. The reason this is bad is that most defict countried rely on their capacity to borrow to fund government spending. If the capital markets close for a country the government has to shut down essentially enacting overnight the kinds of austerity that Greece plans to implement over a period of years. This can result in some serious social unrest.
I really like the phrase "speculative attack" because it is descriptive of the violence with which the markets assualt fixed regimes but to the general reader it may conjure up the wrong image. I think it might conjure up a group of hedge fund managers "speculators" in wearing frock coats and twirling their waxed mustaches while in an oak panneled study somewhere in mayfair they sip sherry and plot the downfall of the countries on the European periphery. This is not what I mean. Regardless of the paranoiac dreams of Angela Merkel the calamity which is affecting Southern Europe is not the result of a plot of some evil speculators. There are in fact very good reasons not to own Iberian bonds right now that have nothing to do with human avarice.
The markets are not driven by a single person or even a coordinated group but they do have definite behavior patterns. I'm going to go out on a limb with an analogy here. Imagine the international capital markets as an inflatable above ground swimming pool with a flexible bottom. Imagine that the water in the swimming pool is all the investable capital in the world. Further imagine that instead of resting the the ground the swimming pool is being held up by a group of men standing underneath it. These men are the worlds central bankers. Ideally all the men holding up the swimming pool would be graduates of a Charles Atlas Program and the bottom of the pool would be level. But that is not the case, the Central Bankers and Treasurer holding up the bottom of the pool vary widely in strength. The weaker they are, the lower thier corner of the bottom. This corresponds to the interest rates they have to pay. Think of a speculative attack as one of the weaker Central Bankers not being able to hold up his corner of the pool very well, and as he lowers his section (raising interest rates) the water in the pool flows toward him making his burden ever heavier. A successful speculative attack occurs when virtually all the water in the pool flows to where the weakest guy is holding it up and then bursts out of the bottom. It's an imperfect analogy but you get the idea. The water does not plan what it does, it simply obeys the laws which govern it. The same is true of investment capital on a macro scale.
Whether this attack succeeds or fails will determine whether we enter a new phase in the credit crisis, a very serve one I think, or whether we shamble on towards recovery and a return to normalcy. A successful speculative attack would involve the markets succeeding in raising the cost of funding for Portugal to such an extent that, like Greece, it was forced to draw down the new EU/IMF package. Now if it did so, also like Greece, it would not have to access the capital markets for several years and therefore would be safe. In fact, Portugal’s funding needs are light enough that it might not even have to go further than the $110 billion balance of payments fund which the EU used to rescue Hungary, leaving the EU/IMF with all EUR 750 billion of their ammunition. The problem would be that once the markets had beaten Portugal, they would move on to Spain.
By the time the attack on Spain began in earnest the markets would have already forced two EU members out of the public markets and would probably have gathered strength from that. If the markets succeed in shutting Spain out of the capital markets then we are in for some serious action. Spain will then have to trigger the EU/IMF funds in order to keep the government running. This will mean that all the EU members will have to go to the capital markets themselves in order to fund the project. This may be no easy task. For example, the German share of the bailout is about 5% of GDP. Given that it’s total debt to GDP ratio is already 80% Germany itself will, after the bailout, have a dangerously high debt to GDP ratio. This is the dark side of the bailout, it blurs the balance sheets of the European governments and makes a speculative attack on Germany a possibility. If that happens, it’s game over.
So right now the most important thing to watch is the Portugese CDS. A lot of people are watching the Euro as a proxy for this but I don’t think its appropriate because ultimately the level of the Euro will have little effect on the availability of capital for Portugal which is the true catalyst for Armageddon. If the markets can push the Portugese CDS over 750 then I think it’s only a matter of time before the gig is up. So if the Portugese CDS is the canary in the mineshaft for Armageddon when will we know that it’s safe to go back in the water? Sadly this is a much harder question to answer and is why I think any rally from this point in world equity markets is likely to be subdued. There is no obvious thing that would make the Portugese problem dissipate. Even if the Portugese CDS comes in the most likely outcome will be further political wrangling within Portugal as to who should bear the costs of austerity and this will likely push the CDS back up.
Personally I think the most likely outcome is that Portugal muddles through, it’s true that it’s in bad shape but it is nowhere near the position in which Greece found itself. It seems also to have learned the lesson of Greece and is actually taking tough measures to bring its deficit under control. Of course if that happens then equity markets will begin to react more to the strong data that has come out of the US and the fact that all this madness means that Bernanke is even less likely to take his foot off the gas. Thus if Portugal calms down enough, there could be a big rally. That said, Iberia is not out of the woods yet and is still very vulnerable to a general flight from risk assets that might be caused by something unrelated to its own finances such as tensions on the Korean peninsula. This thing is not over by a good long way. The only certain thing is that we face significant uncertainty.