Notes From Underground: The Europeans delivered on a bailout of the Peripherals (Maybe So, Maybe Not)

After reading through the vast amount of news on the Brussels “emergency” meeting, I am not sure I truly understand what the final outcome of the European resolutions for financial stability entail. There are bond swaps on Greek debt, which will mean a soft default, and then there is an increase in the size of the EFSF funding and a move to allow the  buying of secondary sovereign bonds. Again, it is not so easily to understand at this juncture as so much contradictory information is being provided that the final agreement doesn’t appear at this time.

It is known that only Greek bonds will be swapped for longer durations but the unknown is what will the other PERIPHERALS ask for if the Greek rates were to drop to levels that make Ireland and Portugal envious. Sarkozy and Merkel seemed to be in agreement on many issues but it doesn’t appear as if there is a EUROBOND yet, which means there is no real movement on consolidation of fiscal policy. President Sarkozy made it seem as if an agreement exists for a European Monetary Fund, which would provide liquidity in emergency situations, similar to the IMF.

The question remains as to where the funds to support an EMF will come from and what country will ultimate backstop the need for the collateral for any future bailout operations. Rates on the troubled peripherals are still very high so it will take time to see how the market will absorb the details. The fact that it was only the GREEK DEBT singled out for some type of restructuring leaves me to wonder what price will be exacted from Ireland when it wants to lower it rates and lengthen its duration. The Eurocrats will demand that Ireland raise its LOW CORPORATE TAX RATE AS A PRIMARY CONDITION FOR DEBT CONSOLIDATION.

There will be funds forthcoming but the demands for a quid pro quo will be exacted. Still, the markets accepted the European plan as a huge increase in liquidity and credit reprieve. As anticipated, the BUNDS were sold off as the other European sovereigns rallied. More importantly, global equities staged a coordinated rally as the world breathed a sigh of relief that another European crisis had been averted. GOLD was sold as the EURO rallied and investors moved from safety to a more risk-oriented profile. Ultimately, the European plan leaves many questions. To paraphrase Churchill: “I cannot forecast to you the action of Brussels (Russia). It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is European (Russian) national interest.”

Yesterday, Brian Sack, the chief dealer of SOMA (SYSTEM OPEN MARKET ACCOUNT) gave a speech discussing the FED‘s investment portfolio. SOMA does all the buying and selling for the FED as it implements its QE strategy. Sack is the FED‘s key man and he now controls the largest DEBT PORTFOLIO in the world. Mr. Sack revealed that the FED‘s portfolio had now extended its duration to more than 4.5 years well beyond its traditional duration of 2-3 years.

“Together, the larger amount and longer tenor of our securities holdings result in a considerable amount of duration risk in the SOMA portfolio, meaning that the market value of the portfolio is sensitive to movements in interest rates.”

This is a significant revelation for it means that the FED is going to have to engage in FINANCIAL REPRESSION as to insure itself against low losses do to interest rate rises. The FED holds more than a TRILLION DOLLARS of 10-year instruments–MBS and TREASURIES. Thus, it is in the FED‘s self-interest to possibly cap long rates similar to the 1940s. Also, imagine the outcome for the FED balance sheet if the U.S. DEBT was downgraded by the rating agencies.

The FED‘s exit from QE2 is going to be a far messier affair than the economic models would indicate. When the FED‘s main BOND trader and portfolio manager issues a warning, it is important to pay close attention. If he is concerned, then we all need to be concerned. Those who say the FED is making money on the QE programs are marking to market and not anticipating duration risk. Time to look closely at the technicals on U.S. NOTES AND BONDS.

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10 Responses to “Notes From Underground: The Europeans delivered on a bailout of the Peripherals (Maybe So, Maybe Not)”

  1. Peter Says:


    1. Greek bonds will be swapped for longer durations


    a) at par

    b) at market

    c) at discount

    d) at premium

    2. where the funds to support an EMF will come from and what country will ultimate backstop the need for the collateral for any future bailout operations.

    a) some form of money printing. They can increase the money supply. Or, they can achieve the same effect by paying more than market for garbage paper

    b) backstop/collateral – will never happen. Greece should have been forced to move all of its gold into a separate vault under the watch of a third party custodian. Will Germany, France, and other Euro-nations put up gold to back their new fund – never. This is just pretend and nothing more.

    3. Mr. Sack – how much money is he willing to print to prevent interest rates from finding fair market value. Or, is he willing to let the stock markets find their own value. In other words, is he willing to scuttle the Plunge Protection Team and fire himself – doubtful.

    4. Time to look closely at the technicals on U.S. NOTES AND BONDS.

    Yra, please let me know one or two rational rules for buying or selling bonds. Here, we are dealing with managers of the Fed, who will do anything to force their will on the markets. Unless collective market forces can overwhelm the printing press, you can not win.

    Possibly, you might make a couple of comments on Bill Gross’s decision to stop going along with the Fed. Pimco seems on the outs now. How much money has Bill made in profits gained or losses avoided by bucking the Fed. I doubt if he is still on the insider list.

    Mr. Bernanke would like nothing more to see Pimco realize a short term loss of 5% to 10% by betting against the Fed. That result would bring all other bond managers in line to keep them in lock step with the Fed. There is nothing better than demoting a high profile General to Colonel – the other Generals don’t want to be next.



  2. Mr.Kowalski Says:

    Might work for a while– but what incentive does Greece and others have now to get their house in order when the EFSF will just keep bailing them out ? Henry Paulson’s moral hazard has returned to visit us.

  3. yra Says:

    Peter–what a wondeful post .I will get to work this morning answering but it requires much thought and is deserving of maybe its own NOTES—-thanks for taking the time.But I hope several readers respond with their thoughts as it is deserving of much consideration

  4. chris Says:

    My only response to Peter’s thoughtful questions is that it implies that the Fed is omnipotent, which it is not. Do they manipulate the market? Yes, at varying degrees and times. Has the Fed smothered a ‘natural’ market response to their actions? I guess that remains to be seen, but I would say no. History has proven the Fed’s machinations have their limits. It’s bonds or stocks- choose which- but it will require the debt ceiling issue to be resolved first. With the treasury/Fed borrow/print mechanism, how can the Fed work their usual magic?

  5. chris Says:

    I should add that I expect they will do whatever they can to avoid losing that power and the debt ceiling will be raised.

  6. fx619 Says:

    Yra: I would like to know more about how to translate all this “talking and thinking and supposing” into the actual “doing” — the execution of actual definitive risk-reward bets — otherwise this blog (like most of the blogosphere) regresses into an echo chamber of futile observation.

    With all respect, it seems to me a huge waste of energy unless one actually proceeds from insight and observation to an actual course of action.

    My attraction to this blog in particular is that you Ira (unlike most of the blogosphere) actually translate this stuff into action — if so please share with us how that is accomplished — any live examples of moving this discourse into an actual course of action where the risk-reward, risk control (stops) and reward potential is definitive?

  7. yra Says:

    fx619–as you know I try to direct you tothe possible trades but I do not provide definitive stop losses as my technical work is not anybody elese’s and is extremely proprietary.But as of yesterday ,i tried to get you to think about profitable outcomes from any event like the european crisis.If you are looking for buy here and sell here this is not youe cite–for that would be touting rather than thinking and doing and you can just watch cnbc for that

  8. laura Says:

    within ten years the euro will cease to exist

  9. Arthur Says:

    Following the discussion. Great article by James Mackintosh (FT, Treasuries lose ‘risk-free’ status): “That will make Greece the first developed country to default since it was last in default in 1964 (according to economist Carmen Reinhart’s history).”

  10. yra Says:

    Peter–My answer to the first question is it appears to be all of the above.Some bond holders are going to get a free ride but if all the banks roll to the 15 year and more 30 dates –looking for 90% acceptance it will be deemded a success.Answer to the second question is of course Germany with the others foreced to go along—Dutch,Finns,Austrians.I think some people are overstating the importance of a weak EURO for the continued success of the German export engine.Yes a weaker EURO helps but it was the work done by Schroeder via Hartz IV—German unions understood that everything changed and were willing to allow their wages to be frozen for job security.German exports ,like Japans,are highly engineered improved quality that the world desires.The Japanese YEN is near all time highs and that export of value added products still performs well—so I would add that those who think that Germany is trapped in a concept of WEAK EURO are overplaying a bad hand.As for MONEY PRINTING–it will happen but that is where the German electorate will be tested for that will remove the curtain from the whole Maastricht sham.Again,if any GOLD is to be pledged let it be done by backing BONDS—think of the Giscard d’STAING bonds issued by France.The IMF should certainly use a GOLD BACKED BOND concept to raise the funds that will be needed.On Brian Sack—I think he is an important policy crafter for the FED and very influential on whatever Bernanke understands about the practicalities of the market.As my friend [JA] has pointed out—Sack gave a speech in early August of 2010 about the effect of PORTFOLIO BALANCE CHANNELS and thus we had Bernanke deliver the Jackso Hole speech.Brian Sack doesn’t have the money printing authority but if he is worried about the FED’s ability to extricate itself from QE policy and thinks the FED has duration risk,then I think it is in the realm of possibility that the FED tries to make a policy like the 1940’s and fix long rates to ensure their ability to escape and let others become “financially repressed”.But the FED is going to be in for a surprise for this is not the 1940’s—GOLD is freely traded and the world has freely floating currencies and very little EXCHANGE CONTROLS.POINT FOUR WILL MAKE ITS WAY INTO TONIGHT’s BLOG.

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