European debt crisis

Tom Tong31/Oct/2011Currency Updates

…and the magic number is….four!

Four times leverage, that is. That is the cabbalistic ratio into which the European conclave has coalesced. This means that somehow, the $440 billion Euros of the initial European Financial Stability Facility (EFSF) will be painlessly transformed into a still undefined amount, which is hoped will be somewhere above 1 trillion. Never mind that the actual non-leveraged firepower of the EFSF is far from clear, due to the continuous downgrades of the countries contributing to it and the need for overcollateralization to maintain a AAA status. Never mind that the actual procedure for implementing this leverage is even less clear – one gets the distinct impression that European leaders think of “leverage” as a modern version of the miracle of the loafs and fishes. Never mind the insanity inherent in the idea that borrowers can insure themselves. Even if we manage to ignore all of the above, there remains the fact that the “leveraged” amount falls well short of the 2 Trillion Euros that are needed to convince skittish investors that Italian and Spanish Government debt is as good as Bunds.

For now the trick seems to be working. Risk assets in general, and the Euro in particular, have exploded upwards in response. The Euro is up over three figures, the Eurostoxx 50 index rose 6% (see two-day minute by minute chart below), and the all-important spread between German and Spanish 10-year bonds compressed by nearly 40 points. You will forgive our skepticism. We have seen this before. Faced with disaster, Euro officials come up with a vague, de minimis solution which kicks the can down the road. Markets explode upwards, shorts rush to cover, and the can gets kicked down the road. Meanwhile, the economic outlook continues to deteriorate, particularly in the periphery, business, consumer and investor confidence erodes further, and sooner rather than later the crisis blows up again. The main change is that the lull between storms seems to shorten with every cycle.

Perhaps the most puzzling part is that these verbal and financial pirouettes are completely unnecessary. The solution is simple, elegant, and relatively painless, but unfortunately involves both the ECB and the breaking of religious taboos. It was almost exactly 70 years ago that the US President Roosevelt railed against “the old fetishes of so-called international bankers” during the World Economic Conference of ‘32-33. Back then FDR referred to the Europeans obsession with the gold standard. His words are equally appropriate to describe the ECB’s attitude towards the crisis: it refuses to participate in the solution, except when reality becomes too painful to ignore, and then does so only in dribs and drabs, buying as little peripheral debt as it thinks it can get away with. The old German fears of Weimar-like currency debasement are driving policy in Frankfurt, a very bad idea. The Fed, the Bank of England, and the SNB to name just three, have already shown that in times of insufficient demand and investor fear, there is nothing inflationary in expanding a central bank balance sheet. No matter; as we point out, German refusal to involve the one institution that could actually solve the problem is, like most religious myths, impervious to reality.

There are two rays of hope. First, the Europeans appear to be willing to concede reality in the case of Greece. A haircut of at least 50% of Greek debt seems certain. However, the Greek economy has deteriorated so much under the weight of austerity and crisis that we are skeptical 50% is enough to make debt service sustainable. Second, Mario Draghi will replace the hapless Trichet next week. Will Draghi have the intention, will and political support to change course? If not, we do not see how the common currency can sustain this rally.

Euro vs Dollar (yellow) Eurostoxx 50 (white) and Spanish-German 10-year spread (green). Daily chart, oct 26-27. From Bloomberg.

Euro vs Dollar (yellow) Eurostoxx 50 (white) and Spanish-German 10-year spread (green). Daily chart, oct 26-27. From Bloomberg.

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Written by Tom Tong

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