Notes From Underground

Last week, the Eurocrats tried to persuade the markets that it has gathered the strength to deal with the DEBT CRISIS IN earnest. But even with three days to analyze and digest the statements it is still not clear as to how the actual bailout will work. The ultimate question: Who will guarantee all the good credit being established that will allow the EFSF to do its job to insure the markets against sovereign default??

Yes, the credit markets for the PERIPHERALS made substantial moves from the very high levels of early last week but for the sake of CONTEXT remember that GREEK 2-year notes are still yielding 25%, Portugal 13% and Ireland 13.5%. The banks signing on to the European bailout seem to be taking a hit on their present holdings of GREEK debt as the debt is rolled to longer durations. It is hoped that 90% of the DEBT will be rolled.

The basis of the banks accepting a hit to their holdings was pieced together by the Institute of International Finance (IIF). It is claimed that the banks offered a “voluntary” decision to absorb some lessons, thus placating the Germans. This concept of VOLUNTARY is suspect as the chairman of the IIF is none other than Josef Ackermann, who is also the head of Deutsche Bank. Do you really think that the gun wasn’t held to Ackermann’s head and, thus, all of the large European banks? It is not a secret that the large German banks are especially vulnerable to a spread of the sovereign debt crisis.

Even though the Europeans claimed agreement, there is definitely a great deal of uncertainty hanging over the EURO DEBT CRISIS. Is there any wonder as to why GOLD continues its rally as none of the world’s reservoir of reserve currency status are receiving the confidence of global investors? In a world of FIAT currencies the CREDIBILITY OF CENTRAL BANKS  and GOVERNMENTS is the LYNCHPIN of the system. In this environment even equities become a viable investment vehicle.

Tonight the S&P FUTURES have opened very weak as the U.S. Congress and President Obama failed to reach any type of deal on increasing the DEBT CEILING WHILE CUTTING SPENDING. It will be important to watch how global equities trade with all the BUDGETARY UNCERTAINTY. Will markets punish the U.S. Treasury market and look to equities as a better value? It seems too early to tell but it is a possibility. There is great concern that a U.S. Government shutdown will create greater economic stress, driving bonds lower as the economy fails to recover. But is U.S. DEBT, in this season of BUDGETARY MALFEASANCE, really the repository of safe and sound investing?

The July 21 BLOG posting drew many comments, but the first entry by PETER was a well thought out query. In the BLOG I stated that it was time to closely watch the technicals of the BONDS and NOTES to determine if support was giving way in the FUTURES markets. Peter states that the BOND markets are overwhelmed with the FED‘s ability to print money and buy up even more TREASURY DEBT, making the short side of the market all but impossible. Even Bill Gross and PIMCO cannot overcome the power of the FED and PETER believes that the FED wants to punish PIMCO and other sellers of U.S. DEBT.

First, there is an interview with Mohamed El-Erian in this week’s BARRON’S and the question is broached about PIMCO’s call on the U.S. Treasury market–PIMCO maintains that they do not have to short the market but rather avoid and seek out other sovereign debt that has much better fundamentals. El-Erian maintains that PIMCO has done exactly that and even as U.S. Treasuries have rallied, the debt of Germany, Canada and others has performed even better. It seems that PIMCO is not looking to fight with the FED or the TREASURY and merely gets to the FUNDAMENTAL HIGHGROUND to serve the best interests of its investors.

For PIMCO it is a win-win by avoiding U.S. DEBT for if the U.S. economy falters all sovereign debt will rally. However, the higher quality sovereigns with sound fundamentals will rally more. This is a short-term view for all overextended nations with control over their currencies and central bank will turn to the printing press.

Again, it is time to get comfortable with the term “FINANCIAL REPRESSION,” a term made popular by the ubiquitous work of Carmen Reinhart. In a March 12, 2011 piece co-authored with M.Belen Sbranica, the authors state in the abstract:

“A subtle type of debt restructuring takes the form of ‘financial repression.’ Financial repression includes directed lending to government by captive domestic audiences [such as pension funds], and [generally] a tighter connection between government and banks. In the heavily regulated financial markets of the Bretton Woods system, several restrictions facilitated a sharp and rapid reduction in public debt/GDP ratios from the late 1940s to the 1970s. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real rates liquidates or erodes the real value of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation.”

This is a very powerful synopsis of why the DOLLAR is always subject to weakness and the GOLD has rallied to all-time highs. The problem for the FED is twofold, as inflation is the medicine and yet through the QUANTITATIVE EASING PROGRAMS, the FED is the largest owner of U.S. TREASURIES, which is why Brian Sack’s emphasis on the FED‘s duration risk should make U.S. BOND and NOTE holders very edgy. Also, as Reinhart notes, the Bretton Woods system was heavily regulated which limited investors’ choices.

Americans were not allowed to trade GOLD until 1975. Currencies were pegged until August 1971 and most countries still had some type of foreign exchange controls, especially during times of economic stress. All those analysts relying on models showing what happened during the last 60 years are suspect as the MODELS fail to take into account how dramatically the global system has changed.

It is why NOTES FROM UNDERGROUND seeks to figure out. Why 2+2 =5 and hopefully profit from the inconsistencies of flawed models. The FED may seek to control the BOND and NOTES as the largest holders of U.S.DEBT. If the BUDGET process spins out of control, the pressure to prevent losses on the FED balance sheet may make the FED seek to cap long interest rates. The only question is: Will a CAPPING OF RATES WORK IN A POST BRETTON WOODS WORLD?

Tags: Bill Gross Mohamed El-Erian, Bretton Woods, central banks, debt ceiling, debt crisis, Dollar, EFSF, Europe, Fed, Gold, governments, Greece, IIF, Italy, Josef Ackermann, Obama, peripherals, PIMCO, Portugal, quantitative easing, S&P futures, Spain, Treasury notes and bonds, U.S., U.S. debt, voluntary

This entry was posted on July 24, 2011 at 7:49 pm and is filed under Debt Market, Europe, United States. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.