A View from the Trenches, February 19th, 2012: "Chronicle of a break-up foretold"
Click on the link to read this article in pdf format: February 19 2012
Today, we want to follow up on the dynamics of the Euro. We go back to our comments since the beginning of 2012, when we suggested that the logical result of the monetary policy the ECB is embarking on is an increase in the velocity of circulation of the Euro.
We also wrote that: “…in the short-term, the demand for Euros does not wane, because sovereign debt is denominated in that currency and the refinancing operations of the European Central Bank facilitate the purchase of that debt. This suggests to us that shorting the Euro will be a painful trade, with very high volatility…” Indeed, anyone with a short position in the Euro knows what we are talking about…
Can we better understand where the Euro is heading? In the past week, some analysts have posited the notion that a default by Greece could have consequences far worse than the Lehman’s default, in 2008. But as we will seek to prove, that may not be the case: A run for liquidity, post Fed UDS swaps (extended in Dec/11) and ECB LTROs (long-term refinancing operations) has left the market less levered in USD terms, which is bullish of risk and bearish of US Treasuries and the US dollar.
We prepared some graphs, adapting for the Eurozone, but based on an excellent paper called “The causes of price inflation and deflation: Fundamental economic principles deflationists have ignored”, by Laura Davidson, 2011. Figure 1 below shows the stocks of the Euro financial system, focusing on the balance sheets of the European Central Bank, the Euro banks and the Euro corporates/citizens (creditors), before the crisis started, in 2010.
Figure 1
As you can see, the ECB holds sovereign debt in its assets, foreign exchange and gold. The Euro banks leverage on their demand deposits, term deposits and unsecured debt (in USD) to sustain long-term loans to both the EU governments and corporations.
At the beginning of the Greek crisis, in 2010, the public in the periphery began to withdraw deposits. The reduction in the deposit base forced the ECB to start extending liquidity lines against collateral. It was the beginning of what would be later called the “Separation Principle”. This principle, conceived by M. Trichet, consists in relaxing monetary policy by influencing the price and the quantity of liquidity separately, without increasing the monetary base. Indeed, the ECB lowered interest rates and at the same time, bought and sterilized sovereign debt (with its own debt). This is represented by Figures 2.a and 2.b below:
Figure 2a
Figure 2b
It is visible from Figure 2.b that the higher demand for Euro liquidity reduced the leverage of the financial system. And, as the ECB extended Euros against sovereign debt, the crowding out of private demand for savings began.
Simultaneously (but shown in different graphs), the market began to sense a contagion in the financial system from sovereigns, and unsecured USD denominated debt began to be called, triggering a further drop (losses) to the equity/hybrid part of the capital structure of the banks. Capital left the Eurozone, as represented in Figure 3 by the increase in USD holdings of corporates/citizens. The demand for USD was so strong that the Fed had to extend swaps to the ECB, to provide USD liquidity to the market. As we said before, these swaps are the equivalent of vendor financing in favour of the counterparties of the global banks (the reader knows who we’re talking about), who saw a sharp increase in the default risk of their trading counterparties. Figure 3 below shows how, steady but slowly, the balance sheet of the ECB grew, while that of the EU banks shrank. Not only did the balance sheet of Euro banks shrink, it also became seriously dependant on monetary policy, both to finance itself and to remain profitable, as an increasing portion of its assets remained invested in sovereign or central bank liabilities. These displaced investments in the private sector, further fuelling the recession.
It is also visible in Figure 3 below, how the size of the balance sheet of the ECB is now impacted by the swaps extended by the Fed. This is why, contrary to popular opinion, we say that since December, the US are coupled to Europe. Yes, this latest rally was based on the coupling (not decoupling) of the balance sheet of the ECB on to the Fed.
Figure 3
By now, it should be easier to see why we began these comments stating that we thing the current context is bullish of risk and bearish of US Treasuries and the US dollar. The Fed is tied to the fate of the Eurozone. And as that fate looks increasingly ugly, it will involve itself more.
There is another effect here that comes into play. On one hand, as banks saw the portion of their funding from equity and unsecured debts shrink, they also saw the dependence on USD denominated debt shrink. The collateralized, long-term (3 yrs) liquidity extended by the ECB, in Euros, replaced it. Therefore, the impact of sovereign defaults on the demand for US dollars, all other things equal, should be lower than before. But not all other things are equal: Given the reduction in the demand of USD denominated debt, the suppliers of the same were forced to invest their USD holdings into loans, bonds, stocks and commodities. It was a virtuous cycle, seen since the end of December, where as the USD funding rates fell, asset prices rose.
Therefore, we find ourselves at higher price levels, with lower rates, less demand for leverage and sovereign defaults fairly priced in. What could go wrong?
In the case of a default that triggers the break up of the Eurozone, we would see a generalized run against the EU banks. This would activate the demand for US dollars (and gold?), which we believe (big assumption of ours here!) would force the Fed to extend more and more swaps, in an effort to save the Eurozone. After all, are we not facing Greece’s default and are we not seeing the ECB holding Greek debt until the last minute? Why would we not see the Fed holding its USD swap loans to the ECB…to the last minute? Precisely this action, in light of the serious set backs to global banks (and the reader knows who we are talking about) would seriously devalue not just the USD, but all currencies against gold, while at the same time, it would be negative for stock prices and, likely, for US Treasuries.
Figure 4 shows, in extremis, the what the financial system of the Eurozone would look like, moments before its break up. There would still be a minimal transactional demand of Euros and the Euro banks would be totally nationalized and heavily dependant of the Fed. The link between the financial and non-financial sector would have been broken, generating a serious crisis, possibly, with high inflation. If that high inflation does not come in then, it would come in later, as the Fed keeps pumping liquidity to the system.
Figure 4
What we just described is the logical consequence of ongoing policies, and it would be very misleading to think of them as “tail risk”. This is no tail risk. If any, the tail risk here is that we see a strong recovery, driven by an increase in productivity. We may be wrong in our assumptions, but we believe that if we are not, our logic is correct (readers’ feedback is very welcome!).
As a consequence, we have been buyers of weakness in gold, believe there is a point in starting to sell strength in US Treasuries and are neutral in stocks.
Martin Sibileau
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