We want to write a few thoughts today, before we leave, on Wednesday, to attend the Austrian Scholars Conference, at the Ludwig Von Mises Institute, in the USA. If we are able, we will write from there our impressions on the different topics and views we encounter.
 
Our recent letters are beginning to read more and more ominous. We think we have been lucky at identifying the main issue affecting the markets these days: The European Central Bank’s policy.
Since Mr. Trichet surprised everyone last week with the announcement that the ECB may soon start hiking rates, investors are slowly starting to realize that if this indeed takes place, the resulting strong Euro will trigger Greece’s default (and possibly others will follow). Underscoring this problem, yesterday Moody’s downgraded Greece’s sovereign risk by three notches, to B1, from Ba1. Greece’s credit curve is already seriously inverted and its 5-yr point is above 1000bps.

Besides a good research note from Bank of America’s Rates Research team, we were surprised and perhaps even angered to see that nobody else has come to the front to call Mr. Trichet wrong. The mainstream story the media was feeding the masses yesterday went like this: “…Stocks are weak (not selling off) because of the uncertainty in the Middle East, which puts a bid on the price of oil. But this shock, which is impacting the “recovery”, is temporary and once this oil “bubble” bursts, the rally will continue. So, back to your point, I see a great buying opportunity, Jim!…”

Those who make these comments also wonder why is it that the Euro is so strong, when Greece is about to default. They see the relationship inversely, incorrectly we may add, for Greece is about to default “because” the Euro is strong. Therefore, we should not be surprised if peripheral bonds drop with the currency strength. We should be surprised if their price actually rose!

 

We don’t know if this should make us laugh or make us feel sorry. Worse, if this situation spirals, Ben Bernanke will be seen a wiser man, for having had the patience, unlike Trichet, to leave rates at negative real values for the “extended period” everyone criticizes today…

In summary, we think there is no buying opportunity here and we even fear that gold may soon no longer resist the deleveraging forces at play, if Greece’s default becomes imminent, once the EU Council meeting of March 24-25 ends without clear resolution on the future of the EFSF. Indeed, if the situation deteriorates, counterparty risk will increase exponentially and liquidity will be sought everywhere. Gold would also be a victim.

We have already dealt here with counterparty risk in sovereign default swaps. This is something regulators have not addressed at all and is in fact the weakest link. Will we see it escalate in 2011? We have no idea, but we must be prepared and therefore, we briefly elaborate on it below:

When a bank sells a credit default swap on a sovereign within the Euro zone, say Greece, it promises to pay, if default occurs, par on the protected notional under the contract. But that notional is denominated in US dollars. As you can imagine, even if that default is caused by a strong Euro, at default, there will be a rush to USD liquidity, as those financial institutions that sold protection on Greece’s sovereign risk need to buy US dollars to deliver on their promise to pay. Therefore, the strength in the Euro that we currently see can swiftly turn into weakness, because in the presence of jump-to-default risk (i.e. right before the actual default takes place), margin calls in US dollars on the contracts will be triggered, to mitigate counterparty risk.
Now, at this point, it should be clear that this counterparty risk will violently transform into systemic risk. Funding in US dollars, within the Euro zone will be limited, pushing Libor higher and leaving the Fed without a choice. The Fed will need to extend currency swaps to the European Central Bank. Why? Because at the end of the day, the ECB will have defacto renounced its monetary authority. The funds that Trichet refused to print on March 3 would eventually be lent, in multiples, by the Fed to European (and non-European) banks. Will Congress allow this? Until this point, gold would be under a lot of pressure. But it would soon become clear that the Fed cannot bail out the entire world and gold would then reach unthinkable highs.

Could this actually happen? It all depends on what the EU Council decides on March 24-25. Until then, in our personal accounts, we want to hold cash and gold. No stocks or bonds. Not even energy stocks or gold mining stocks, for they end with the word “stocks” and that will be enough for margin clerks to sell them (the case was made yesterday, as both gold and oil managed to make intraday highs and yet, the respective energy and mining stock ETFs sold off).

Lastly, it will be very useful to understand that for this to happen, it is not even necessary that the ECB actually hikes rates. In fact, we think there is a chance they won’t. However, with last week’s threat, the technical damage has been done.

 
Martin Sibileau