Notes From Underground: Greece is the word and it is getting ancient

We have been writing about Greece since the end of November and the constant chatter about the PIIGS is getting tiring and boring. The Trichet-Merkel-Sarkozy tango is losing its beat as the curtain of opacity has been raised on the inner sanctum of European politics. The European Union was crafted as an attempt to harness the German economic engine to the global aspirations of French return to imperial glory. The French elites have been very good at encouraging the eurocrats to subvert democracy within Europe. (Case in point: Whenever there was a negative vote on any referendum, the result was always a do over until the desired result was achieved.) An Irish no vote was not a problem because if the French threatened the Irish with the removal of money transfers, the vote would change. The ability to undermine democracy was always assured as long as Brussels could use the carrot of monetary incentives.

Now that the Bavarian burghers have said no to economic reparations for their profligate brethren, the fabric of politics has indeed changed. There is a great piece in tomorrow’s Financial Times by four German economics professors who had filed a case against the EURO in 1998. The case, which was filed in the German Constitutional Court (GCC), claimed that the entire EURO violated the 1993 Maastricht Agreement, as the accounting practices used to meet the Growth and Stability Pact’s requirements undermined the rules for stability. The COURT denied the case, but as the piece says, this time the GCC may decide the other way, thus bringing down the curtain on German involvement in the EU.

This is why the Greek debt situation has become a sideshow as the Franco-German drama now is front and center. We believe that Merkel could end this by simply demanding that Weber becomes the ECB president and declare victory for the Germans. Some analysts assert that Merkel is more concerned about appearing to cave in to European chicanery ahead of a very important regional election on May 9. If Merkel’s coalition were to lose this election, her coalition would lose control of the upper house of Parliament and wouldn’t be able to craft tax legislation. This variable in the equation, plus time, is not on the side of a Greek solution.

The professors in the FT piece suggest that Greece should exit the EURO and relist the DRACHMA, but we think this is a flawed solution. It would be better for Germany to leave the EURO and allow the rest of the European problems devalue against a revived DMARK. We know this will not sit well with many but when you think about it, this is far easier than awaiting the exit of the next PIIGS and watching another crisis infect the world’s financial structure.

Now on with the show. The U.S. debt markets are the second important story. The long end of the bond market has been under severe strain this week as the near-end of the FED’s QE, and massive supply of long-term bonds, has allowed the bond vigilantes to gain the upper hand. The heavy selling has driven the 10-year note up more than 20 basis points the past two days, and by the end of today the selling finally took its toll on the equity markets. If the short end of the curve remains stable and the result is a steepening curve, the equities should be able to sustain its recent rally. The interesting fallout from the sharp rise in the long-end yields will be the effect on the DOLLAR. If higher rates are a result of U.S. fiscal profligacy, then the DOLLAR will come under pressure. But if the higher rates are in anticipation of more robust  growth, the DOLLAR rally should be sustained.

We will be watching this development but right now the picture is difficult to ascertain because of the European political situation. We think that the Britsh pound becomes important in helping get a better handle on this, for if the pound could assert itself on some of the crosses, it would reveal that the problem was EURO-related rather than anything too positive about the DOLLAR. Interestingly, the British gilts have actually held up well on a relative basis, but the global financial situation is as difficult mess as we have maybe ever experienced. For consolation we advise reading Rudyard Kipling’s poem, IF.

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