Click here to read this article in pdf format: november-24-2010

We usually publish on Mondays, but this time, we wanted to see things play out before coming back. We stand therefore by our forecast published back in September, when most saw the European Financial Stability Facility as a source of strength for the Euro, while we publicly disagreed: We saw this facility as a the key that would trigger chaos within the Union. The chart below (source: Bloomberg) redeems us: the Euro fell by four cents vs. the USD, since the Irish requested access to the facility.

In our last letter, we suggested that the best way to understand the ongoing action within the EU is to use a “game theory” approach, of a non-cooperative nature, we should add. We put forth three main players: Ireland, Rest of peripherals and Core Europe. Now that the bailout for Ireland is news, a new dynamics unfolded. Early yesterday, Bloomberg reported German Chancellor Angela Merkel declaring that the prospect of serial European bailouts was “exceptionally serious”. However, we listened to the speech ourselves (Click here to watch it ) and believe the press may have taken Ms. Merkel out of context, which implies that the markets may have overreacted but also, that there is more in hand here .

Now that Ireland seems to have gotten away with its corporate tax structure, other “participants” in line (i.e. Portugal) have learned something: Time is on their side. Why? Because marginally, once a country’s sovereign yield shoots up and becomes the next in line, the marginal pain is bigger for Core Europe. When Greece’s bubble went bust, Ireland felt the pain, Core Europe barely felt it. When Ireland’s bubble goes bust, Portugal feels the pain and Core Europe begins to take notice. By the time Portugal’s bubble goes bust, the pain for Spain will be felt and Core Europe will be very uncomfortable, since France or Italy will be the next in line and Germany simply can’t afford this.

Therefore, the sooner Core Europe deals with Portugal, the cheaper it will be to cut the pain. How does Core Europe force Portugal to come to terms? By pushing their sovereign yields higher than the policy makers of the first-in-line countries expected. How? By going on record, like Ms. Merkel did yesterday, saying that the situation is exceptionally serious. That way, Portugal’s credit risk jumps 35bps to 490bps threatening with a margin increase at LCH Clearnet. This move leaves the first-in-line country unable to raise capital and asking for help to the EU and European Central Bank (sooner, rather than later! This is the point!). To us, this makes sense…Otherwise, why would someone as serious as Ms. Merkel say what she said with such a brutal sincerity? When are politicians sincere?

Where does this all leave us? It leaves us with a change in our view: We think the EU is far more serious about the survival of the Euro than we had previously thought. The problem is nevertheless still institutional, the Euro will have to continue depreciating and fiscal austerity will remain in place. However, if they succeed, it may well have again a chance to become the world’s reserve currency, if the US doesn’t correct their monetary mistakes. Why? Because the only way to succeed is through a dramatic institutional change, a true federal pan-European structure. In the meantime, the opportunity to become a reserve asset grows for gold by the day, because the risks of failure are just too big to be ignored.

Martin Sibileau

Please, click here to read this article in pdf format: november-18-2010

A quick note to finish the week…We think we are entering a new stage in the dynamics of the Eurozone, and that the ongoing negotiation between Ireland and the European Union as well as the weakness in the Euro prove that the comment we made on September 9th was appropriate. We wrote:

“…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 )

Since November 4th, the Euro has embarked on a very defined downward trend. Counter intuitively, this should not occur.  Ireland does not need to access the market before June 2011 and if it required funding, the European Union is ready to sign the cheque. Therefore, what is behind the weakness?

To understand this issue and our previous comment, we need to see first that Europe has first and above all an institutional problem. Secondly, one can use the Game Theory approach. We are not well versed in this approach. We studied the theory while as undergraduate students and thanks to the extraordinary advancement of mathematics, we know it has evolved tremendously since John von Neumann and Oskar Morgenstern first published in 1944 the famous “Theory of Games and Economic Behavior”. We are very reluctant to use formal approaches to human action but we think the particular negotiations that are currently taking place can be easily analyzed under this method. Here are what we think can be premises:

1.-Ireland’s financial position, just like any other peripherals, deteriorates with the passage of time. However, as it does not require funding until June 2011, its position vs. time is stronger than that of Portugal or Spain (i.e. the first “derivative” of loss vs. time is lower for Ireland. But not the second. By 2011, everyone is on the same leveled field ).

2.-Ireland knows (1) above (i.e. has perfect information) and uses this upper hand to better negotiate the terms of the inevitable bailout. However, if it waits too long, the advantage is lost.

3.-Portugal, Spain and Italy know (i.e. have imperfect information) that once Ireland gets help via the EFSF, spaces will fill quickly. There isn’t simply enough room for everyone. The EFSF cannot be but for exceptions. Otherwise, there is no catch! An EFSF for everyone can simply not be AAA rated: A bank that lends with leverage cannot honor all deposits at once. Furthermore, keep in mind that there are no defined pan-European taxes supporting draws under the EFSF, but a promise from each respective EU member to get those funds somehow (Another important aspect here is that the IMF is contributing an additional 50% , which a friend and reader pointed to us is simply another important source of debt monetization).
Therefore, once Ireland draws under the EFSF, a race will start by Portugal, Spain and Italy to win the next seat, to be the next in line to draw, before the window closes. Be ready. All kinds of tricks and influences will be played at this point.

4.-Core EU members (i.e. Germany, France, Netherlands) know that the puck must stop somewhere, before their own solvency is compromised. If it is compromised, the only way out is a blanket, wide monetization of government debt by the European Central Bank, a massive currency crisis, assuming the EU monetary union doesn’t break. What are they doing about it? Ms. Merkel has been pushing to for the creation of a debt crisis mechanism, in which an “orderly” bankruptcy is carried out and whereby sovereign bondholders take a haircut. This is simply a wrong and absurd idea, which if implemented, it will only accelerate the demise of the monetary union. On this note, we think it is worth reading UBS Tommy Leung’s recent comments (UBS EU Credit Stategy – Daily Morning Walk, November 16th, 2010: “A glaring contradiction”) where he reflects upon this issue. Mr. Leung observes that this mechanism would discriminate between sovereign debt issued prior and after 2013, effectively creating a two-tiered EU sovereign debt market. This actually goes against the natural solution for Europe, which is a unified bond market! In this scenario, bonds issued prior to 2013 would be structurally senior to those issued from 2013 on. Mr. Leung further asks how would this be consistent under Basel III, where banks holding these bonds assign a zero risk-weight to them. Clearly, if a restructuring mechanism is considered, the possibility of default cannot be ignored.  Mr. Leung leaves the topic here, but we don’t. If default cannot be ignored, the arbitrage within the EU financial system will be immediate, with depositors shifting their savings from the banks holding the subordinated bonds to those holding the senior bonds. This can only deteriorate the balance sheet of the European Central Bank.

Where does all this leaves us? What can core EU members do? Nothing! Absolutely nothing. What will they do? Force more fiscal discipline on the other peripheral countries. But as we saw in point 3, once Ireland access the EFSF, these countries will have a strong incentive to fill in the last seat available. In other words, they will seek to show they can’t survive without it.

The US cannot react to this, as it is too concerned with its own problems. The latest performance of municipal debt is very telling in this respect. How can China react? By holding lower amounts of Euros as reserves and shifting that allocation to gold, slowly but steadily.

Lastly, we want to bring collective attention to the recent pressure the Fed is facing. Not only is there internal dissent regarding QE2, but also on Tuesday, as everyone must know by now, an open letter to the Fed was published by the Wall Street Journal, criticizing this latest move. Now, at our desk, we always have Bloomberg TV turned on and yesterday we noted how guest after guest was asked by different news anchors whether the Fed should not reconsider its dual mandate. Once an answer was given, the Bloomberg anchors replied asking whether Mr. Bernanke would likely resign on such change, noting that this is a possibility, given the new Republican majority in Congress. Are we thinking too much here? Were we watching a press op unfold or was this pure coincidence?

Martin Sibileau