Please, click here to read this article in pdf format: march-23-2011

Since we last wrote a week ago, nothing of fundamental weight has changed (being this the main reason for our absence).
It’s true, unlike last week, the markets now see the nuclear disaster in Japan contained and, perhaps too, something close to a “managed” transition in the Middle East. Even if it takes a coalition to apply force and even if it is not clear what the main goal is and which country actually leads that coalition. It doesn’t matter. Stocks kept rallying until Monday and credit spreads continued tightening.

However, there is a key assumption behind all this behaviour. As Portuguese and Irish sovereign risk widens, the main assumption that prices seem to be signaling is that there will be no domino effect, should any these countries, and Greece, have to restructure their liabilities. To be honest, these countries are already undertaking a restructuring, although with those liabilities related to the bailout effected by the European Union. Interest rate decreases, term extensions and liquidity lines are all undeniably telling a story of restructuring.

The main assumption then is that as the EU funds, via the European Financial Stability Facility or via purchases or liquidity injections by the European Central Bank, are applied to simultaneously avoid a default and allow the Euro to strengthen, the problems will not spill over to Spain or Italy. If that is the case, we can justify the rally in stocks, the tighter credit spreads, the price of gold and WTI oil above $1,400/oz and $100/bl, respectively.

We will not write about the politics taking place in the background, as the EU negotiations are carried out. Ireland is still fighting to keep whatever trace of sovereignty has left and the symbolic 12.5% corporate tax rate that Brussels wants dead seems to be the last line. Portugal is playing games with the EU and Greece does what it can to show that somewhere down the road, default is avoidable.

The message we want to leave today is this: In order to (a) avoid a domino effect in the EU involving Spain and Italy and (b) remain with a single currency called Euro… whatever final form a debt restructuring is pushed to take, the EU will have to avert by all means a run against any country’s banking system.

The first thing that is crucial here is to send a clear message that there will be a lender of last resort, if there is a run against deposits in a country’s financial system. This goes against Trichet’s notion that it is possible to establish what he called a “separation principle”. The ECB cannot sustainably switch (it has not done so yet, but it has sent the message it will) from fixed rate to variable rate auctions and at the same time raise interest rates, within this fiscal context. In the long term, it cannot even sterilize either (When the ECB offers liquidity at a fixed rate, Banks can take all the liquidity they need, at a fixed price. Effectively, the ECB loses control of its balance sheet. When the ECB offers liquidity at a variable rate, Banks can only bid for the amount offered by the ECB, and the rates are the product of the auction process).

So far, a retreat of 30-50bps in stocks yesterday may be telling us that the market is giving the EU and ECB the benefit of the doubt. If you are a gold bug, you want the ECB to push this inconsistency further, for it would bring the collapse of the monetary union, making room for gold to take over. If the ECB backs off and postpones the “separation”, showing it is there for the banks, then the road up for gold will be a rough one and marked by the next fiscal crisis: That of the US.

Martin Sibileau