Please, click here to read this article in pdf format: november-9-2010

Having dealt with the implications of QE2, the market has repriced and now shifted focus to the situation in Europe. We should have published yesterday about this, but we had already anticipated problems in Europe when last week, right after the US Federal Open Market Committee announcement, we wrote:

“…the creation of a crisis resolution mechanism without addressing the root of the problem, namely the absence of a real federal structure in the European Union with a unified bond market, only adds one more layer of complexity to the still alive uncertainty generated by potential contagion from the periphery to the core of the Union. A crisis resolution mechanism is buzzword for confiscation, for wealth redistribution from bondholders to governments. There is no other rationale for bringing this up, except to ensure that in the future, investors in sovereign risk see their seniority status diminished, subjected to the arbitrary designs of a crisis resolution council. This idiocy or naïveté, we don’t know which, will do nothing but make Euro sovereign debt more expensive to raise, in a more volatile, less liquid market, if the reform advances. It will certainly put a cap to the value of the Euro and a cloud of doubt to its prospects as a secondary reserve currency…” (www.sibileau.com/martin/2010/11/04 )

We stand by these comments, which differentiate us from the mainstream explanation of the ongoing situation within the European Union. While some (refer D. Gartman in his letter of Nov 8th, 2010) see US dollar strength rather than EUR weakness and others attribute the weakness to the fiscal situation in Ireland, we strongly believe that the weakness which commenced right after the announcement of QE2 was triggered by this institutional development that Germany is working on behind the curtains. Germany has brought this unnecessary bout of sovereign risk entirely upon itself, for one has to be insane to go public suggesting that in the future, investors in sovereign risk will be considered as participants in future bail-ins.

True, the article by Prof. Morgan Kelly on the Irish Times (http://www.irishtimes.com/newspaper/opinion/2010/1108/1224282865400_pf.html) only made matters worse at yesterday’s open but it is clear to us that the weakness started with the speculation of a ridiculous “orderly” bankruptcy mechanism for EU sovereigns. Was somebody surprised to see that nobody has a real grasp on what the actual debt burden on Ireland will be? Was anyone in awe to learn that the final bill of the bank bailouts is pharaonic? Who did ignore the problem mortgages represent there? No, this was not news. The German draft on “orderly” bankruptcies is the news. The Euro turned to the downside on last November 4th and more importantly, the recent spike in sovereign risk has not yet been transmitted to the broader Euro financial sector, as the Euribor – OIS spread continues to be in the low 20s bps.

Is there time to revert this? Possibly, but only if Germany really shows leadership. Peripherals debt, like any other debt upon which hesitation grows requires an increase in the collateral or a guarantee. In this case, increasing the collateral would mean opening the door to future privatizations, just like what the Brady bond restructuring brought about in Latin America. That, for now, seems not to be in the cards. Therefore, the only way out here is to show a guarantee. The fact that we see a recent spike in sovereign risk is proof that the European Financial Stability Facility (http://en.wikipedia.org/wiki/European_Financial_Stability_Facility) cannot be trusted, in our opinion. We already wrote, back on September 9th:

“…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…” (www.sibileau.com/martin/2010/09/09 )

Lastly, we watch with interest the developments in the long-term part of the US yield curve (i.e. 30-yr Treasuries). Although most would argue this is simply a correction to match the Fed’s 5-7yr average duration purchases through QE2, we think something else is in the works here. Such a correction should, in our opinion, have been completed last week. Yesterday’s increase in the 30-yr yield and simultaneous rise in commodity prices represents the very early stage of the upcoming US sovereign crisis.

Martin Sibileau