Please, click here to read this article in pdf format: april-26-2010

We left our desk on Friday with a smile. Post-Goldman and with the seriousness of the Greece drama, we stuck to our view that nothing fundamentally had changed and that the rally in stocks would continue. And it did, with the S&P500 index closing at 1,217.28pts, the Canadian dollar still not below parity and gold stronger.

We like a quote from a certain Macedonio Fernández (http://en.wikipedia.org/wiki/Macedonio_Fernández ) that we believe has never been more proper to describe market sentiment these days. It goes like this: “We easily accept reality, perhaps because we intuit that nothing is real”. Paraphrasing then Mr. Fernandez: “The markets accept (and rally on) the reality of increased sovereign risk, because they intuit that nothing is real, that deficits shall be monetized and that this too shall pass.”

Today, we would like to write about fundamentals or the latest developments in the credit markets. But unfortunately central banks and governments continue to be the main drivers behind all action these days. On this basis, let’s take a quick bird’s-eye view on the drama.

In Europe, we have a relatively minor government that is technically insolvent and is seeking financial aid from the Union. This aid will come by way of guarantees on their sovereign debt by banks of other Union members (i.e. Kwf Bankengruppe). However, we all know that a Kfw bank can provide that guarantee because at the end of the day, the European Central Bank stands behind. It is the same central bank that will take the guaranteed debt at par and issue Euros in exchange, if liquidity is required by a financial institution holding that sovereign debt. This type of debt monetization is subtle. Herr Schmidt in Hamburg, M. Dupuy in Paris or il signor Michetti in Milano will not notice it. None of them will see their taxes raised. Even if we wanted to explain it to them how their savings are being taxed, the explanation would require a minimum understanding of basic accounting principles. If Herr Schmidt has “ein Sparkonto beim Kfw Bankgruppe” he won’t suspect at all that the collateral supporting his Konto is a mere illusion. When do these people get a hint of what’s going on? Come next winter, when they want book their week-long all-inclusive trip to the Dominican Republic, they will realize their savings are not as good as they were a year ago. Maybe it won’t matter…Maybe they will vacation in a Greek island after all. Why not?

What is the lesson here? The ECB has its hands tied and hikes in policy rates cannot happen any time soon. The Euro will continue to be tossed off the proverbial cliff. But the question here is: What will the Euro fall more against, in relative terms? The USD? The CAD? Gold?

In our view, speed here is of the essence. If the Euro devaluation is not carried out in order, global liquidity will be affected. If it is orderly carried out, then the quiet and underlying shift of other central banks’ reserves (i.e. Russia, China) out of the Euro and into the CAD, the AUD or gold will be more relevant, in relative terms. Hence, it is key to understand what can cause a “disorderly” devaluation of the Euro and what is its corresponding likelihood. We think that anything that hints towards the dissolution of the monetary union, institutionally, will generate confusion and disorder. Under this scenario, Euros, gold, CAD, AUD and commodities will be sold, while USD and US Treasuries will be bought. Anything else that hints towards a slow and steady debasement of the Euro, will favor gold, CAD, AUD and commodities, at the expense of USD and US Treasuries demand.

We believe the underlying theme in this approach cannot be captured by quantitative analysis. Institutional risk would be the so-called tail risk, leaving statistical inference useless (But feedback here is welcome). Therefore, one has to be able to read between the lines, into the messy political game that will unfold before our eyes. One must not underestimate the institutional problem of the European Union. It is not circumscribed to Greece. It involves the future monetization of Portuguese and Spanish deficits as well. It may even involve a bailout of Spanish financial institutions.
Any maneuver by the ECB to gain independence and keep up with an exit strategy, regardless of the fiscal situation of EU members, will open the door for the IMF to play a bigger role and create uncertainty as to which alliance between other EU members (i.e. German-French) will fill the gap. This type of scenarios will favor USD assets. By the same token, any validation by the ECB of sovereign deficits (i.e. extension of emergency liquidity lines for up to BBB+ debt) should push gold, CAD, AUD and commodities higher, at the expense of USD and US Treasuries. One last caveat here: This market thesis assumes things in the US and China remain “stable”.

Martin Sibileau