Trader’s Review of the Week; 10 and 11 September 2011

[private] Saturday 10th September If (Greek) Government can’t meet aid terms, “It’s up to Greece to figure out how to get financing without the Euro Zone’s help” Mr Schaeuble German Finance Minister

The above is a direct quote of the German Finance Minister, Mr Schaeuble, during a closed door meeting of German politicians late last week. The Germans, as are most of the Euro Zone, completely fed up of the Greeks, and cannot rescue the Euro Zone as it is politically and financially impossible. The Germans have been uber generous to date, but even they do not have unlimited financial resources. The Troika (EU, CB and IMF) revisit Greece next week, to discuss Greece adherence to their fiscal commitments (or lack of it).

The Greek PM and the Finance Minister now state the Greeks will implement the terms of their aid package, though I believe they wont and, indeed, cant. Having lied to get into the Euro and having lied again and again, I cannot have any sympathy. Besides, did they really believe they could survive within a currency union? However, I totally accept that Greece should have been allowed to default much earlier. Not only would it have been better for the Greeks, but it would also have been much cheaper. Once again, Trichet and the ECB were totally wrong, though amazingly, they persist with this position.

Greece may just get a little more aid, as the Euro Zone still (unbelievably) have not figured out how to deal with a Greek default, but as I have mentioned, Greece will have to default this year.

The German’s are working on the basis that a Greek default will result in a haircut of 50%. However, in reality it will be well above 70%, as they will discover soon enough. Even though such a haircut is a certainty, the Euro Zone, including most European banks, can survive it.

Those who do not survive will be bailed out, but expect shareholders (and bondholders) to take the 1st hits this time, absolutely rightly so in my view. Yet, what the European banks cannot survive is contagion spreading to Italy, Spain and other Euro Zone countries. As a result, the ECB will have to step up its purchases of Italian and Spanish bonds. I believe it will, as it has no other choice.

Legislation to authorise the changes to the Euro Zone’s bail out Fund, the EFSF, are likely to be passed by no earlier than October, though there are some who suggest it will take until December. Counter intuitively, it will be easier for Euro Zone countries to pass the EFSF legislation, if Greece defaults, as the whole collateral issue disappears, which is what has been demanded by the Finn’s.

The next big issue is whether the Euro Zone can stop contagion spreading and, in addition, finally face up to the fact that European banks need to be recapitalised, having at least started to address the whole issue of losses on Sovereign bonds holdings. There is no reason why the ECB cannot continue to buy the appropriate Euro Zone bonds as it does have unlimited buying power. Indeed, if the focus switches to the EFSF, there will be more of a credibility issue, particularly as we all know its size is limited to E440bn and there is little (current) inclination to increase its size.

Whilst the ECB has learnt that it must continue with its bond buying programme to gain the credibility that markets need, it clearly finds it difficult to admit its 2 recent rate hikes of 25bps each were a huge mistake. Mr Trichet, last Thursday, stuck to his very boring line, though it was far more dovish than the previous month.

But his game is to preserve his reputation and legacy, rather than do the right thing and admit that he and the ECB made a mistake with their recent rate hikes and will have to reverse its decision. This same mistake was also made in 2008, and they had to reverse them soon thereafter too. That’s my problem with the Euro Zone and ECB, it is full of grossly overpaid bureaucrats, who are financial amateurs learning on the job and learning it all very slowly.

I, really cannot understand the market reaction to Stark’s resignation, it was great news in my opinion. Everyone knew he was opposed to the ECB’s purchases of peripheral Euro Zone bonds and was unhappy that his concerns were not being listened to. His likely replacement, Mr Jorg Asmussen, a State Secretary in the German Finance Ministry is far more canny, extremely competent and less a hardliner on monetary policy, exactly what is needed at present.

He is also extremely articulate and credible. I believe he is also close to the opposition German party, the SPD, who are more Euro Centric. I can understand the Euro weakening on the obvious fact that the ECB will have to reduce rates, and most likely by 50bps by the year end. However, as we all know, Asian Central Banks (especially the Chinese) are buying the Euro, as will the SNB shortly after (to defend the E1.20 peg against the Swissy), as markets test the SNB’s resolve.

However, the Euro remains fundamentally overvalued at these levels, in any event and, in my opinion, will decline further. I am very much looking forward to the departure of Trichet, though I will miss him. And having lost the dreadful former UK PM, Mr Gordon Brown, my other major bête noir, I am going to be at a loss if I cannot find someone else to rant over. However, never fear, this is the Euro Zone and there will be plenty of up and coming candidates.

A number of people are calling for a break up of the Euro Zone, what with a number of countries exiting the Euro. Personally, I have come to the conclusion this is highly unlikely, but with the exception of Portugal. The cost would outweigh the benefits.

If on the other hand, Germany and a few other countries exited the Euro, their resulting currency would be the equivalent of the Swissy, but even more liquid, as the currency would soar and the German export industry would be crushed. Some countries may leave, for example Greece, though Portugal looks exceedingly vulnerable, but the cost for most countries of exiting will be horrendous, both to themselves and the Euro Zone.

What happens next? Well, the Euro Zone will cobble together another elastoplast kind of solution, which means we will head from one crisis to another. This would be great for people like me who play this game, but really dreadful economically, particularly for the longer term. Eventually the Euro Zone will issue Euro bonds, countries will have to meet pre determined fiscal targets, which will be subject to verification. They will have to stick to this, and then European banks will be recapitalised, etc.

It’s just unfortunate that politicians are incapable of sorting this out sooner and without the inevitable and increasing pain. Though with how the current situation is, they will only move when there is a crisis. In my view this shows sheer lack of leadership, and totally criminal.

Whilst the German’s will hate it, the Euro Zone will have to print money at some stage. It has been the traditional escape route in the past and will be used once again here. In addition, the ECB will have to reduce the interest it pays on deposits held with it, as will the FED. Goldman’s have talked about the FED, in addition to operation twist, i.e. QE3, announcing that interest rates will be linked to the unemployment rate. 

This weekends G7 meeting came out with the same platitudes and very little in terms of policy action. President Obama’s US$450bn plan sounds great, but I can’t see the Republicans supporting it meaningfully. The worse the economy, the better their election chances. Government policy action is desperately needed as a matter of urgency, the markets cannot sort out this mess. However, it’s tough to see any sensible people or plan out there at the moment.

All of this is great for you gold bugs, though given the current and likely higher Gold price, I would have thought the way to play it is through unhedged gold stocks, this would result in gold miners are finally making money, rather than the commodity itself. My friends, who are totally plugged into this sector, suggest silver stocks will be an even better play, they have been right so far.

Sunday 11th SeptemberGerman Constitutional Court ruling may we force Euro Zone countries to default

Chinese inflation declined to +6.2% YoY, though food prices remain a serious problem. However, whilst inflation may spike in the next month or so, it appears to be declining. The PBOC is likely to be less hawkish, particularly given the slowdown in the global economy.

The Chinese August trade surplus shrank to US$17.8bn, from US$31.5bn in July. Exports rose by +24.5% YoY, higher than the +20.4% increase in July. However, imports rose even faster by +30.2% YoY, much higher than forecasts for an increase of +21%, mainly due to restocking by Chinese companies of raw materials. There have been many calls that the Chinese trade surplus will shrink and may even become a deficit.

However, a lot of the products exported by the Chinese simply cannot be sourced through other countries, certainly at present, even if prices are increased. This suggests to me that Chinese trade surpluses are here for longer. Chinese lending rose by Yuan 548.5bn (US$85.9bn) in August, this is above forecasts for an increase of Yuan500bn. M2 rose +13.5% YoY, lower than estimates of +14.2%.

There have been endless rumours that Reliance, one of India’s largest companies, has had a far too cosy relationship with the Indian Government. Reports released by the Comptroller and Auditor General (CAG) state that capex cost of gas production by Reliance Industries (controlled by India’s richest man, Mr Mukesh Ambani) were US$8.8bn, much higher than the US$2.4bn estimate.

In most cases this would be considered a problem for the company, but not for Reliance. Most of the funds were paid by the Indian Government. In addition, Reliance was allowed to retain a number of acreages which they should have given up, according to the CAG report. BP has now agreed to take a stake in Reliance Industries. However, given BP’s unerring talent to get it somewhat wrong is a cause for concern. Either way, the increased focus on corruption in India will have a major impact on the performance of a number of Indian companies.

Christine Lagarde has been questioned by European Finance Ministers for a report, produced by the IMF, which suggested that European banks needed some E200bn and Governments should force mandatory recapitalisations of the relevant banks. The reality is that European banks will need far more, though the Euro Zone is, as usual, in total denial. This plan to deny is getting very tedious indeed. Do they not know that markets are not that stupid?

Bloomberg reports that ECB is to dilute its attempts to wean European banks off emergency funding, using higher interest rates. Essentially, the ECB will ask financial institutions, together with the relevant national Central Bank, as to how they intend to repay the funds. Does this suggest they did not do even the most cursory of credit checks before they provided emergency funding?

The reality is that the collateral received by the ECB is effectively toilet paper, certainly in respect of Greece, and they will face significant losses. How will they cope, given their extremely limited capital? They could ask Euro Zone Governments to make up the loss, though this will be embarrassing for them, or they could print money.

The amounts involved are huge. Irish banks borrowed E97.9bn in August, Portuguese E46bn and the Greeks a staggering E103bn, as at the end of June (this is the latest data available and likely to have increased since then). However, Mr Trichet is exiting at the end of October and it will be Mr Draghi’s problem thereafter. This is very much in the Trichet style. I still can’t forget his recent press conference where he stated the ECB’s performance had been “impeccable”. When the inevitable chickens come home to roost, I wonder whether someone will replay that?

The Greek PM vowed that the country would meet its fiscal targets and to press ahead with structural reforms, involving inter alia the sacking of some 20,000 civil servants. There were violent protests at the speech. Greece cannot and will not deliver and the rest of the Euro Zone does not believe that they will. A default is a certainty and will occur relatively soon.

Recent reports suggest that US money market funds have been reluctant to provide short term financing to European banks, this is no great surprise. Analysts suggest that European banks face a US$500bn dollar funding gap. The problem is that the cost to swap Euros into US$ has jumped fivefold, for example to 103bps for 3 month loans, from just 20bps in June. This extra cost is extremely serious for a number of European financial institutions.

In addition, recent data also suggests there has been a withdrawal of deposits by Europeans from European banks and the proceeds deposited with US banks (source: FT). Just to add to the pressure, there are reports that credit agencies (Moody’s) will downgrade French banks imminently, such as BNP, Soc Gen and Credit Agricole were placed on review for a possible downgrade in June.

The impact of the recent ruling by the German Constitutional Court is likely to have a far more serious impact on the Euro Zone than suggested by the initial headlines. Essentially, it prohibits the German Government from accepting permanent rescue mechanisms a) if they involve a permanent liability to other countries, b) if these liabilities are large or incalculable, and c) if foreign governments can trigger payments under guarantees, as a result of their actions.

If this is the right interpretation, the EFSF is OK, however it ceases in 2013. But its replacement, the ESM, which is a permanent mechanism, is not. Furthermore, it also suggests that a Euro bond will fall foul of the ruling as they are permanent and will be large.

In a previous ruling, the German Constitutional Court stated that any transfer of fiscal responsibility to Brussels would require approval through a referendum. In the current climate, the Germans will not vote in favour of such a possibility.

This ruling is the killer for the Greeks and, virtually certainly for the Portuguese as well. They will have to default and restructure their debts. Fro the Irish it is touch and go, but if the global economy continues to weaken, it looks like they are in trouble too.

The ruling also means the ECB will remain the only player in town and they are extremely reluctant participants.  In addition, European banks will need a lot more capital to meet losses on their holdings of sovereign bonds.

I suppose you could have a constantly rolling ‘temporary’ mechanism, but that seems likely to be challenged. Another alternative could be unsterilised QE by the ECB, but that is an anathema to the Central bank. I will need to re check this carefully given the extremely serious implications, but on the face of it, it looks like being a real problem. The stakes have been raised sky high.


Trader X is a pseudonym. The author is a former senior corporate financier at a prominent London investment bank who now manages his own money from his homes in London and the West of Ireland. [/private]