Please, click here to read this article in pdf format: march-29-2010

The main factor driving last week’s action was the summit of the European Union, and its declarations regarding Greece (We could also include the US Healthcare bill as another factor, but its consequences are still unclear). In particular, France agreed with Germany to allow the IMF to be engaged in a potential aid package. The reaction from the European Central Bank (ECB) on this resolution was mixed, with Mr. Trichet first suggesting it was a “bad idea” and later supporting it…. The ECB has no alternative but to show support.
We bring Greece’s situation to your attention today for two reasons. The first one is related to our comments back on February 10th  (refer: www.sibileau.com/martin/2010/02/10 “An Institutional perspective on the Euro”) when we had anticipated this outcome. Back then we wrote:
“…If the IMF has to intervene, the European Union will definitely be a Confederation. This is unfortunately the path of least resistance. This is the easiest and less painful path.  If the IMF is engaged, the Euro will no longer be considered an alternative global reserve currency and the bid that there was under such belief will no longer be there. We shall be sellers of Euros under this scenario. This is the worst-case scenario, for if the EU citizens lose purchasing power, the global recovery will become a long-term dream. Note that we don’t care about Debt/GDP ratios or other metrics. The relevant issue here is that on the margin, the Euro would no longer offer more safety than other strong, healthy currencies. In fact, its complex institutional framework would be a burden, compared to other ones, simpler to understand…”

The second reason is related to our comments back on January 7th and 22nd (refer: www.sibileau.com/martin/2010/01/07 “Don’t forget Greece” and www.sibileau.com/martin/2010/01/22 “What are they thinking?”). Last Thursday, the ECB decided to extend its emergency collateral rules into 2011.  The decision was naturally welcome by Greece, with Prime Minister G. Papandreou explicitly saying it will “greatly assist banks”. We had also anticipated this move, when we wrote:
“…Whatever assistance Greece may get from Europe will not be explicit. Nobody will face the scrutiny of public opinion or the moral hazard of such a move. As I wrote earlier, I believe Greece still has a lot of tricks at hand that can use to its benefit, to keep financing its current deficit. One of them is with the private placement market. If Greece continues to use it, selling its debt to local banks (which take deposits in Euros), then Greece will have infected the Euro zone with its disease, forcing the European Central Bank to provide liquidity lines to its financial system. This would be a hidden way to support the deficit and I would be surprised if it is not explored…”
We are not gurus. We do not have the crystal ball at “A View from the Trenches”. If we were able to predict this, it is because we’ve seen and lived through it before. Greece in 2010 is going through the same dynamics Argentina went through in 2000. When we identified this link between the ECB and Greece, we suggested to focus on the spread in the credit default swaps market between the National Bank of Greece SA (NBG) and Greece’s sovereign risk. We chose NBG only because its credit default swap is the most liquid of the Greek banks’ financing the government. As you can see in the chart below (source: Bloomberg), this spread has widened since we first addressed it on January 7th.

It is clear that the “infection” of risk transferred from the sovereign to the financial system is in full effect, with Greece’s sovereign risk now tighter than that of its banks (We understand (but cannot confirm) that Greek banks already have bought half of this year’s issuance by the Greek government). If the ECB validates this transfer, something to monitor as the collateralized BBB- liquidity lines are used, the spread should narrow to lower absolute levels. What would have given in then? What will have been the escape valve to address the imbalance? The value of the Euro, which should fall (all other things equal), with this quantitative easing measure. Therefore (as we warned on Dec.17th (www.sibileau.com/martin/2009/12/17 ), on occasion of Greece’s initial EUR2BN private placement) , all those who invest their savings into Euro-denominated assets will be subsidizing Greek taxpayers. It is a hidden tax, and one that neither Merkel nor Sarkozy need to explain to their constituents. For the rest of the world, in our view, this loss in European purchasing power will be a drag on global economic growth.

Another point we would like to make here is also related to the summit of the European Union as well as to our comments on Canada, made on March 4th (www.sibileau.com/2010/03/04 ). Essentially, we have put forward the notion that Canada and the Canadian dollar are no longer receiving just the “commodity bid” (i.e. “mercantilist bid”), but also the “safe-haven bid”. We suggested that to visualize this, one could follow the spread between the ETF “XIU.TO”, that tracks the S&P TSX 60 composite (orange) vs. the ETF “IGT.TO”, which tracks the price of gold, in Canadian dollars. We updated the chart first shown on March 4th, below (source: Bloomberg):

This spread widened as the Greek situation worsened, as anticipated back on March 4th, and it tightened last week (i.e. as gold increased in Canadian dollar terms, the TSX fell), following the summit of the European Union. We think this proves our point.

And lastly, a word on “method”, as followed at “A View from the Trenches”. On Mach 22nd we said that “…What is about to happen politically and in terms of monetary policy has never been seen before. Therefore, any quantitative assessment done based on historical stats will be pure misleading inference…”

Think about what we’ve done above: We proposed a theory (hypothesis), suggested a proof (thesis, i.e. focus on the spreads described above), and later tested the hypothesis (demonstration: sovereign vs. financials spreads, and XIU vs. IGT). We like the deductive method because we think that there is nothing more practical than a good theory. Other analysts play a pure inference game. They take observations going back to the ‘70s and give you, for instance, the inferred probability that a certain event will trigger an expected result. We think this inductive approach is misleading and totally clueless, although it always looks more “scientific” because those suggesting such inferences are statisticians providing trading ranges. However, we could provide trading ranges in our deductive approach as well (We don’t provide trading ideas in this letter for obvious compliance reasons though). The trading range game and its cousin, the so-called “tail risk”, is what gave birth to correlation books and to synthetic CDOs among other things, and we all know how it all ended. They were the product of inductive reasoning.

Martin Sibileau