Please, click here to read this article in pdf format: november-29-2010

We start the week with three main themes, plus the absence of one. Indeed, yesterday the EU/IMF disclosed the “85 Milliarden Euro Rettungspaket für Irland”. So far, this is to the best of our understanding, what has been agreed to:

-In terms of sources, das Paket will consist of EUR17.5BN contributed by Ireland + EUR22.5BN contributed by the IMF + EUR22.5BN contributed by the European Financial Stabilisation Mechanism + EUR17.7BN by the European Financial Stability Facility  + EUR3.8BN in bilateral loans from the UK + EUR1BN in bilateral loans fra Sverige og Danmark.

We note that the sources of the EUR17.5BN Irish support will be Irish Treasury (yes, I know…) and the National Pension Reserve Fund (no different than what Kirchner did in Argentina a few years ago, when the private pension funds were nationalized and put to good use financing the federal fiscal deficit).

-In terms of uses, das Paket will assign EUR10BN to capitalize Irish banks, EU50BN to cover budget financing needs and EUR25BN as contingent banking support. And here is where things get rather interesting…After Kanzler Merkel would threaten with haircuts on senior bank debt holders, European finance leaders yesterday had to commit to a plan, post-2013 (i.e. when temporary crisis facilities expire) that would treat writeoffs only on a “case-by-case” basis (as reported by Bloomberg), addressing “collective action clauses”. In our view, although this offers a bit of calm to investors, the “technical” damage has been done and it will be difficult to repair, unless there is now an explicit rejection by the EU finance ministers on the issue. They don’t want that? Fine, Mr. Market will eventually force their hands. Just sit tight and watch… What’s next now? Portugal?

The second theme that will impact this week’s action, and perhaps more to come, is the situation in the Yellow Sea, between the Koreas. The recent mediation by China to hold discussions among the Koreas, Russia, the US and Japan smells to a set-up to us, to buy more time for North Korea. It raises the question too, of whether this would have all not been planned before hand. Now, if South Korea rejects the invitation, it will look bad on them. If they don’t, nothing will come out of it, except that the dictatorship to the north will have won time. This could have been a great opportunity for China to demonstrate they are politically up to their pretension to be a global superpower. Because nothing will be solved, in our view, Asian stocks will be capped on their potential to the upside and the price of gold will keep a premium.

The third theme in our view is the expectation, after Black Friday, that consumer spending is slowly recovering and that this will be a force behind a “trend to rally”. Certainly, the recently announced $600BN monetization of federal debt by the Fed (also known as Quantitative Easing II) will also keep a bid on asset prices.

Lastly, another theme is actually the lack thereof, that we may see more clear if and once the public becomes comfortable with the situation in the EU: Namely, the lack of an exit strategy in the US. See, since the beginning of this year, the EU has been working towards gaining trust. Let’s recap:

 First, nobody thought they would pull out a spending cuts program. But so they did! We now have spending cuts from Ireland, UK to Greece. Yes, citizens protested big time, but the cuts are here to stay. Yes, they are not enough, but there is always more to cut and privatizations have not even been discussed yet. What about spending cuts in the US? 

Later, nobody believed the EU would really pull out a package for Greece. Yet, they rescued Greece and now Ireland. They even worked out a mechanism to address future crisis and most importantly they put deadlines to them: 2013. What did the US do on its municipal and state debt problem? So far, the municipal bond market suffered a huge outflow of money two weeks ago and Wall Street is making every effort to downplay the issue, as we expect of course, from those who make money distributing this debt.

Finally, the European Central Bank stated that their government purchase bonds would be sterilized. Nobody believed them (we included) and nevertheless, they did so issuing their own debt (EUR65.8BN at Nov 24th) and without driving rates to expensive levels. What has the Fed done? This is all brewing USD weakness in our opinion and it won’t be long till we see it bursting.

 
Martin Sibileau

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