Please, click here to read this article in pdf format: september-09-2010

After a long weekend, the market has reviewed the fundamental aspects of the current circumstances we are in.

In the case of Europe, investors are beginning to remember that the peripheral countries were not in good shape and that regardless of the time passed, the level of activity, and hence tax revenue, has not improved as hoped or expected. On top of this, the banking system is now seriously infected with sovereign risk, a situation that would have not occurred, if a restructuring of sovereign debt had instead taken place. Problems are therefore “in crescendo” because fixing the banking system unionwide demands now the cooperation of different institutions that sooner or later, will risk their political capital: The European Central Bank (ECB), to begin with, Parliaments, the International Monetary Fund and regulators.

The latter decided yesterday to delay to 2013 the introduction of higher capital requirements for banks. We are not believers in higher capital under a central banking system, simply because the only thing that can prevent a liquidity crisis is the full (100%) coverage of deposits, which precisely eliminates the necessity of a central bank and regulators. Increasing capital requirements under these circumstances not only delays the day of reckoning, but also makes the wait more expensive.

In the US, nobody is surprised by the weakness in activity. There is growing concern about its sovereign risk however and we are witnessing a volatile, gradual bear steepening of the yield curve so far in September (refer chart below, source: Bloomberg)

Is this a long-term trend? We don’t think so. At least not yet. We believe that the time to short Treasuries will come with the simultaneous repudiation of the US currency. But the USD, although weaker vs. the Yen and Swiss franc, is still stronger vs. the Euro. This mixed picture for the USD, we think, is the result of central banks coordination as well as investors’ efforts to diversify. Why now? Because not only is the USD expensive in terms of absolute carry (i.e. not only is it expensive to park capital in US sovereign risk at record low yields), but also in relation to the Euro. Indeed, at some point, interest rates differentials start to weight in (as opposed to growth outlook differentials, which explained the rally of the Euro to 1.331 in August). Below is an update of the spread between liquidity costs for USD and Euro currency zones (source: Bloomberg)

As is evident from this chart, the spread between the currencies’ liquidity costs has widened dramatically. In the near past, this widening reflected on the massive depreciation of the Euro. Today, not so much: The Euro has fallen from 1.33+ to 1.27+ vs. the USD. Why? We think the current situation in Europe is seen as temporary, again, and guess that the market is marking time until the big refinancing transaction due on September 30th (EUR132BN/3months; EURBN18BN/6 months & EUR75BN/1-yr), with the ECB, takes place. As that date approaches, the elections in the US will get closer too and the fragility of the financial shape of municipalities and states will be exposed, and the USD put to the test.

Two last comments here. We’ve come across research that forecasts the Euro at between 1.29 to 1.36, entering 2011. There is nothing strange about this, except the fact that that same research sees US yields sustained at even record lower levels, not seen yet. This analysis is obviously based on equilibrium models and assume a steady state. In these scenarios, a run against the European Central Bank driven by political stress within the European Union is called “tail risk”. Along the same line, a crisis of confidence on the Euro financial system, reflected on higher rates volatility is called “noise”. These models also view the credit event of a municipal issuer as “tail risk”. The slow, so-called below “potential” output (a Marxist concept we also disagree with, because it fully ignores the role of prices in the allocation of resources) is a possible, normal and steady state.

We can only disagree with this vision. In fact, to us it is perfectly normal to see a credit event under high unemployment and slow growth. It is really fully expected to witness a crisis of confidence in a banking system that can only live off a central bank. By the same token, it is the rule and not the exception, to see political stress driving the weakness of a currency whose only real problem is of an institutional nature. To us, the opposite is true: We think that under the current macro conditions, the tail risk is that we do not see a crisis of confidence. That would really surprise us!

Another interesting perspective is that which finds strength in the Euro, from the fact that peripheral countries can now access the European Financial Stability Facility, which is now effectively operational. We actually see it the other way: Precisely because the weak countries will access this facility, the break of the European Monetary Union will be accelerated, as the rich countries are faced with true costs; costs which until now were being piled under the big rug (the balance sheet) of the ECB.

Martin Sibileau