Please, click here to read this article in pdf format: february-7-2011

We start this week with what we ended the last one. In our view, the two main concerns or sources of volatility that remain from last week are the situation in Egypt and the uncertainty over the future scope of the EU’s European Financial Stability Facility (EFSF). The picture out of the US or the UK is decidedly one of inflation, monetary expansion with all the known consequences. Out of  China, we expect no news on rates or credit manipulation (i.e. reserve requirement ratios) until March (the PBoC recently conducted Rmb300 bn of reverse repos).

With regards to the political situation out of Egypt, we know as much as anyone else: Nothing! But here’s what we think, and which we understand may not be shared by many: A shift towards democracy in Egypt and the rest of the Middle East is bearish for oil. Regardless of who inherits power in the area, the new political class will need revenue to appease public employees and the people in general. Without the ability to coerce, the new leaders will need to buy peace and will not care a whit about the origin of their much needed funding. This means that the OPEC will slowly become irrelevant, as member countries need to place their produce with urgency, at any price. Along this same rationale, we should not worry about the Suez Canal. Every ruling party in Egypt needs it open to profit from the toll.
So far, we are at the very early stages of a more general transition in the Middle East. On this basis, we preferred not to trade last week’s increase in the price of oil. Instead, we chose to be net long of Canadian energy stocks, with the belief that capital within the energy sector will leave the Middle East, looking for safer jurisdictions.

We now want to turn the readers’ collective attention back to the European Union. If you’ve been following us, you will know by now that we have been bullish of the Euro. During the past week, uncertainty grew around the final shape that the EU will give to the EFSF. On Wednesday, Bloomberg reported that “Germans” were ruling out bond buybacks. This was a scenario that we had analyzed in detail in past letters and it was a scenario that made a lot of sense to us. Upon seeing this title, which unfortunately moved markets, we thoroughly read the article and found that the title had been horribly misleading. In the end, the EU leaders met on Friday only to postpone any fundamental decision around the EFSF, until March.

However, we understand that some speculate that the EFSF could buy sovereign debt currently being held by the European Central Bank (ECB). We really ignore what the final decision will be but warn readers that such a scenario (EFSF sourcing sov debt from the ECB) is different from the one we analyzed two letters ago. In fact, the outcome would be radically opposite to what we expect, if the EFSF bought sovereign debt from EU banks. Here’s why, in summary:

To buy sovereign debt, the EFSF must raise funds, Euros, in the market. This takes liquidity from the financial system. If the liquidity is then used to buy assets (i.e. sov bonds) from the ECB, these Euros will be taken out of circulation (i.e. assets and liabilities of the ECB will decrease). Therefore, not only will the EU witness a crowding out of private in favor of public credit. On top of it, the amounts of Euros in circulation will drop, raising rates.  This would not occur if the EFSF bought the sov bonds from the EU banks (see our letter of Jan 28th). Under both scenarios, the Euro strengthens. However, if liquidity drops because the ECB sells its bonds, the exercise is recessive, affecting the profitability of banks and the competitiveness of those countries the EFSF was set up to help. Should this occur, we think the possibilities of a successful monetary union in the EU would be seriously challenged, and we would use the initial strength in the Euro to quietly shift to a very liquid USD denominated portfolio. Remember that EU sovereign credit default swaps are denominated in USDs…

Martin Sibileau