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Unfortunately, the theme we began elaborating on January 28th, has now become “the” theme, particularly since this weekend, with Japan’s nuclear disaster and the anarchy of the Middle East as backdrop.

What was the theme? The theme has been and will continue to be the EU institutional crisis. Since March 3rd, when the European Central Bank let it be known that future rate hikes were on the way and since March 11th, when the EU decided that the funds from the European Financial Stability Facility were not going to be used for sovereign bond buy backs (in the secondary markets), a slow but certain chain of events began to unfold, for the worse. These two new “variables” pushed peripheral sovereign debt spreads wider, putting Portugal out of the market. The situation is still not reflected in the ratings, since technically Portugal’s credit risk is still investment grade, after S&P’s recent downgrade to BBB from A-. Nevertheless, last week Portugal’s Primer Minister Socrates offered his resignation.

In summary, the lack of “wise” institutional moves by the EU is resulting in political changes. Last weekend, the CDU, Germany’s official party, lost in the election that took place in Baden-Wuerttemberg. Now, not only do we face uncertainty over those countries that need to undertake huge fiscal sacrifices, but we also face uncertainty over those whose shoulders were originally relied on to back the structural reforms.

As we wrote in our last piece, the only reason this mess hasn’t yet become a brutal correction, is the implicit belief that the bucket stops here and Spain will be spared. That is a strong assumption and the onus to prove it befalls to those who trade upon it. We certainly don’t belong in that group.

Since we are discussing assumptions, let’s bring another one to the table. This latest one is perhaps more interesting and consists in believing that the fiscal crisis in the US can last forever. Indeed, we were totally surprised to read a few research notes over the past weekend, reaching the same bearish conclusions we have, but on a different, inconsistent, ground. The bearish thesis these analysts elaborate are based on the expectation that the Fed will first finish all quantitative easing policies with QE2 and then embark on rate hikes in 2012. This is nothing else but saying that: (a) these people really think that QE2 was about financing negative real rates for the private sector, and (b) the US will embrace historical fiscal policies that will reduce deficits, thereby making the Fed’s intervention in the Treasuries market unnecessary.

For consistency’s sake, there cannot be a different way around this. If you believe US dollar rate hikes are coming, you must believe in (a) and (b) above. However, we think there is convincing evidence that neither the Fed is buying Treasuries to support the private sector nor has the US even begun to imagine fiscal austerity. Therefore, the rate hikes view, if correct, should actually be bullish, not bearish: If you think the rate hikes are coming because you assume the Fed has done a good job with QE2 and because fiscal deficits are on the path to shrink, you have no reason to be bearish. Yet, the recommendation by those who believe in (a) and (b) (for instance, refer Barclay’s Global Outlook: “Winding  down the recovery trade”, March 24th, 2011) is bearish.

We are bearish, but exactly because we don’t believe in (a) and (b), and therefore, we think that once the Fed finishes QE2, it will be more than evident that there was no other game in town. And that recognition, if the Euro one doesn’t kick in first (the EU council is set to meet in June, to decide, once again, the final shape of the EFSF), will set the tone for the rest of 2011. Unless the cards materially change here, we fear that this story is not going to have a good ending.

Martin Sibileau