Notes From Underground: A Major Point of Clarification

It has been brought to my attention that many readers believe my continued criticism of the European financial markets equates to an OUTRIGHT BEARISH POSITION on the EURO. I have not discussed being short euro unless it is on some cross-rate without any DOLLAR exposure. My continued hammering of the European situation is to minimize exposure to the European banks and financial institutions that so many pundits continue to promote. THE EURO HAS BEEN BULLISH BECAUSE THE QE PROGRAMS PROMOTED BY THE ECB HAVE CONTINUED TO BE PAID DOWN, (UNLIKE THE U.S. WHERE ANY TALK OF TAPERING RATTLES THE GLOBAL FINANCIAL MARKETS). Less ECB liquidity floating in the markets has been a positive factor for the EURO CURRENCY, especially during the time of political buffoonery in the U.S. Money flows out of nervous emerging markets has avoided the DOLLAR and sought refuge in the world’s next largest reserve currency, the euro. Even with the positive forces pushing on the euro, there are other currencies that have RECENTLY outperformed both the DOLLAR and EURO: the Aussie, kiwi and even the lowly British pound. Until the ECB has to pump liquidity into the system to avert some problem bank or sovereign, the euro is a difficult short.

Many central banks are adding euros to their reserves as disgust over the recent political turmoil in Washington provides a clarion call for the need to diversify one’s asset base. Relatively high yields in the Italian, Spanish, Portuguese and Irish sovereign debt markets make a compelling argument for building a euro basket of debt. (This is especially the case as so many international analysts are maintaining that Europe will have a unified banking system, with the ECB as the supervisor.) Many investors are accepting that there will soon be a EUROBOND to replace the debt of each individual nation, with a unified guarantor. So much of the investing taking place in European assets is on high hopes that the Germans and other creditor nations will backstop the entire financial system.

More discussion about this very subject took place this weekend via a letter that Bloomberg referenced, written by Mario Draghi to the EU on July 30. In the letter, ECB President Draghi maintains that public funds should be available to troubled banks without wiping out junior bondholders. “Requiring junior bondholders to take losses, as seems to be implied by the revised state aid guidelines, could negatively impact the subordinated debt market, which would in the future be wary of a non-resolution probability of conversion.” If there is no public commitment without first losses being taken by the less senior creditors, then the banks are going to have to pay a much higher price for capital. The German banks and corporations will be at an enormous advantage for the cost of funds will be dramatically lower. This is the issue of FRAGMENTATION in the financial system that Draghi is so desperate to alleviate. If problems arise in the sovereign debt markets the issue will become as crisis because local banks own so much of their sovereign’s debt.

An example is Italy whose banks balance sheet are loaded with Italian sovereign debt. This has the makings a negative feedback loop. Higher local borrowing costs result in greater potential fiscal deficits when money is needed to bail out troubled financial institutions, which of course causes the price of the sovereign debt to fall just when capital needs to be raised. Mr. Draghi is saddled with a real dilemma and he received another bit of bad news this weekend when German FM Wolfgang Schaeuble reiterated that germany would not support EU-wide backstops and wants private investors and national resources to be the first line of defense. It seems that President Draghi needs to relearn Mel Brook’s first law: “It’s Good To Be The King.”

In further noting potential problems for European finance, the FT’s Wolfgang Munchau has a piece, “Italy Misses the Chance to Reform.” Munchau raises the issue of Italy’s most recent budget proposals, which have caused the previous PM Mario Monti to resign from his party. Mario Monti is beloved by the Eurocrats in Brussels so his unease about Italy’s potential for fiscal reform should cause AGITA for euro policy makers. As Munchau writes: “Cutting Italy’s high labor taxes sits right at the top of almost every reform agenda.” But if Italy’s government is to cut taxes on the hiring workers, then spending cuts or other tax increases are needed to ensure Italy meets the promised narrowing of its deficit. Further, Munchau makes the most poignant statement: “I am not a supply sider, but if you have locked yourself into a monetary union with a competitive Germany, it is hard to maintain high levels of labor taxes. Unless you find a way for Germany to adjust to you–dream on–you have to adjust to Germany.” This succinctly sums up the immediate issue for Italy and the other peripheries. Trade wisely and invest accordingly (as my friend JA would say).

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5 Responses to “Notes From Underground: A Major Point of Clarification”

  1. Chicken Says:

    Despite Germany, these bank stocks will rise to new-found glory as if nothing ever happened. It’s the old same magic over and over, rinse and repeat!

  2. CHT Says:

    If they are not capable of understanding you are not outright short the Euro, they probably shouldn’t be reading this blog.

    Yra your take on the political economy is consistently fantastic, perhaps to avoid this perhaps you could always encourage readers to field you more questions?

    I’m sure they’d be interested in the how you use price action and technicals to inform your trading decisions…

  3. Dustin L. Says:

    Yra-Could one not make a strong case that a major reason the ECB hasn’t had to step in and provide more liquidity and banks have been able to pay down the LTRO has been because of continuing QE? It would seem to me that while the focus has been on the taper hitting developing economies which have seen hot money flows, which is reasonable, few have talked about the effects it could have in forcing the ECB to provide it’s own liquidity rather then getting a free ride on the back of the Fed. I am not sure when the renowned taper will happen and it is quite disappointing that the Fed let there last chance pass them by. But, the USD seems bound to make rally before the taper occurs as markets are always forward looking and this move should be Euro bearish. The higher the Euro goes the worse the situation gets for Europe’s competitiveness and the better the short opportunity becomes. There are no sure shot trades but if one can use their technicals to find a low risk entry in the coming weeks and months on the short side of the Euro it could be very rewarding. As always this is easier said then done. The debt deal and no-taper may have provided a nice correction to fade at some point. As always risk first, reward second.

  4. yra Says:

    Dustin–you raise an important point.The ECB has definitely rode the FED’s back even though the ECB was initially more aggressive then the FED–Draghi was able to attain some stability but as in July 2012 we will watch the yield curve and the short end -2 year notes—to locate rising stress within Europe.While the Greek 10 year note has fallen the country still does not have a two year note listed—The taper is still on the table especially if Bernanke wants to appear to be beginning the process before leaving office and give Yellen a running start.

  5. Alex F Says:

    Thursday’s PMIs will be important to watch. We’ll see if the data validates the positive European sentiment…

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