Europe's last weapon

Despite ECB’s recent rate cut, the Euro remains as strong as ever. It’s easy to imagine Mario Draghi pulling his hair out: just what does one need to do to force its currency lower and boost Europe’s peripheral economies, especially in a world where every other major central bank seems to be running the printing press at full tilt?
Sadly, the answer might be, to join them in the global exercise of quantitative easing. The favourite analogy I use to explain QE to my grandma goes like this: it’s sort of like persuading a massively obese man to do some exercise and walk to work by offering to buy his car for a price that he simply can not refuse. Despite the fact that many see QE as the very embodiment of evil, it’s still better than doing nothing, and that “nothing” seems to be an accurate description of the other politically-acceptable alternatives.

Europe ’s macro indicators have looked rather grim lately. One figure sums up the parlous state of affairs: the eurozone inflation at 0.7% is currently lower than that of Japan (1.1%). If it goes any lower, and as rates are already close to the zero bound, getting inflation back up again could be extremely difficult. In fact, it may be impossible. You can’t wait till you are caught in a storm to think about purchasing an umbrella.
Also, some economies in the eurozone are already in deflation. Would you buy something today if it were cheaper tomorrow? Countries that are undergoing structural reforms may well need negative real interest rates. Extremely low inflation militates against structural reforms.

What ammunitions does the ECB have left then? Rates can go lower but there is barely any room left. I can’t quite imagine negative deposit rates in a major currency. Of course the Swiss embraced this a long time ago, but somehow I feel that all things Swiss can effectively be confined to a little box that works in a parallel financial universe with zero gravity where expensive mechanical watches and mountain shaped chocolate bars operate in their own airport duty-free shop of Lalaland.

That leaves us with QE or something that subtly resembles it such as OMT and LTRO. My earlier comparison of QE to overpaying a fat man for his car is a little mean but fair. QE works by reducing the returns on assets like bonds to the point where other activities become interesting to investors. This is definitely a rather roundabout way of driving money into the real economy but it might just work.
It will not be easy politically by any means: open splits on national lines will emerge and Bundesbank will have an enormous fit. It might be unsuitable for Germany and might cause asset bubbles. But this is true in exactly the same way that the monetary policy pursued before the crisis was ill-suited for Spain and did indeed create a property bubble on those beautiful Spanish beaches. Any central bank tasked with the job of delivering a target rate of inflation in an union of vastly diverse economies will destabilise some of its members at any given point in time. This is akin to complaining that “each carriage of this train has its own engine and conductor!”. It’s a description of the whole damn point of a currency union.

I don't mean to imply that using the printing press is an intelligent choice for the ECB, nor is it a solution. Nevertheless, absent a revolutionary political change, it’s Europe’s last weapon. We can lament the political deadlock that has left Europe with a partially zombified financial system. But given a choice between zombies with and without QE, evidence probably support the former.

Cyprus: Mission accomplished?

Last night my newsfeed was full of pictures of a middle aged German woman in her black bathing suit while on vacation in Italy. Despite of the less than pleasant attention she received from the local Italian press, the German chancellor certainly deserved a short holiday following the Cyprus fiasco. From Angela Merkel’s point of view, the past couple of weeks have been if not a complete triumph, a respectable success. The German chancellor showed her constituents that she drove a brutal bargain.

The details of the Cyprus rescue have become increasingly clear and most publications talk about the €17 billion bailout calculated assuming that it would provide €7 billion for the banks and €10 billion for the government. It’s worth noting that the final plan provided not a single Euro for the banks who ended up having to raid their depositor base to come up with the whole €7 billion.
Of the €10 remaining billion, €7.5 billion is being used to refinance maturing debt. It doesn’t take an Einstein to work out that this debt is mostly pledged as collateral at the ECB. Consequently if the tiny island of Cyprus defaults it would take out a large portion of the equity capital of the ECB. While it is not a matter of public record it is estimated that Cyprus has guaranteed more than €10 billion of collateral at the ECB. So, the €7.5 billion is being lent to Cyprus in order to be paid right back to Europe. Given that, it is perfectly fair for me to say that on a practical level, the EU bailed Cyprus out for FREE!

The Troika is very emphatic about what the future of bailouts looks like. Nevertheless the head of the Eurogroup and Dutch finance minister Jeroen Dijsselbloem was pilloried for announcing that so-called “bail-ins” — forcing shareholders and large depositors rather than taxpayers to take the hit when banks fail - should become the norm in the eurozone.
The timing could not have been worse and his remarks immediately spooked the financial market. Aside from the incitement to panic, there is actually plenty to like about this in principle as it’s consistent, transparent and it doesn’t ask taxpayers to write blank cheques - we all know that blank cheques are a dangerous, dangerous species.  Mostly importantly, the new template is progressive – things that hurt only people with more than €100,000 tend to be.
Except it won’t work. The obvious issue is that depositors over €100,000 control enough money to overturn the European economy if they stampede. When I first started my career in derivatives trading, the first lesson I learnt was that the price for 1 billion is very different from the price for 1 million multiplied by 1000. You can not play and experiment with money on this scale unless you have planned a fully controlled detonation of a massively complex and fragile system.
Mr Dijsselbloem’s remarks would have been taken more kindly had the Cyprus operation gone well. It didn’t. The so-called rescue has inflicted massive, irretrievable destruction on the economy of Cyprus. The capital controls currently in place are draconian. There will be a forced rollover of debt. Cheques may not be cashed. Business working capital is frozen. Basic cross-border trade is severely curtailed. Credit card use abroad will be limited to €5,000 a month. And in spite of the above, the money will still leak out of Cyprus even if the island gets encircled with razor wire.

If Macdonald’s tested a new meal that killed 10% of the sample group, it is reasonable to assume that they’d hesitate with the global rollout of Cyprus HappyMeal. Instead, the Troika is clapping the dust off its hands, announcing that they think the Cyprus mission is accomplished, and looking to have another go somewhere else.

When you cross the Cypriot Rubicon

I wake up on Saturday morning (okay, maybe midday) in a Warsaw hotel to the news that the people of Cyprus have been unceremoniously sacrificed as part of a 10bn bailout agreed in Brussels. The BBC reports that one man has parked his massive bulldozer(!) outside a Cypriot bank. Well, if 10% of your money was suddenly seized from you without any warning to “bail out” the banks, and the remaining 90% was completely inaccessible, it does seem somewhat logical to park your bulldozer in front of any one of the said banks.

The troika meeting where the above decision was taken started one hour after American markets closed for the weekend.  In the wee hours of the morning, the troika came to a conclusion and announced their idiotic plan to recoup cash directly from all bank deposits in Cyprus.
Specifically, Cyprus is imposing a levy of 6.75% on deposits of less than €100,000 - the ceiling for European Union account insurance, which is now effectively gone - and 9.9% above that. The measures will apparently raise €5.8 billion.
I heard various rumours about this previously, but never believed for one second that anyone would actually be foolish enough to implement what has been the biggest taboo in European bailouts to date - the  impairment of depositors.

They’ve crossed the Rubicon. So here is what I think will happen on the short term:
1. EUR/USD tanks. US treasuries sky rocket. Good thing I’m positioned the right way.
2. Cypriots empty all ATMs and banks in Cyprus. Yes the 10% might be gone but there is nothing stopping anyone taking out the remaining 90% now. A quick search found that the loan to deposit ratio for Marfin Laiki bank stood at 156%. Bad news.
3. Half of Cypriot bank tellers take a sick day on Tuesday.
4. Berlusconi and Grillo open bottles of champagne to celebrate being given the biggest piece of ammo they could have hoped for. They start running new campaigns telling voters their bank accounts will be empty if they don’t jump ship from the EU.
5. I can’t quite predict Russia’s reaction but undoubtedly not just Russians but very wealthy, and very trigger-happy Russians will be absolutely FURIOUS.

On a longer term:
Cyprus will NOT have a sustainable debt load of 100% by 2020. There is NO way. We know all too well that outrageously optimistic forecasts are being used once again to make it appear that this bailout will lead to sustainability. Even my 80 year old grandma can hear the unmistakable sound of the Cypriot can being kicked down the road.

Pandora's box

It's been an exhausting day today, deal flow very much swung between feast and famine. There was relief as the resolution of the debt ceiling wranglings finally came. I found it incredible that even at the eleventh hour, 26 members of the Senate still managed to vote against the legistlation, with the alternative being a US default(!).

Still, the fix is in and we can finally go down to the pub. There I meet one of my friends who was quietly celebrating some serious profit - he had been short Pandora stock (Danish jewellery maker) since May! I never saw the appeal of Pandora and their silly looking charm bracelets which also happen to be enormously overpriced for a mid-market brand. At the time I was telling him while shorting pandora he could go long the luxury high end and the low end in the same industry. I feel that in the follow up to a recession consumers tend to drift away from the middle ground. This guy was so stubborn and so sure of his view that he didn't even bother hedging with a spread position. Pandora share fell more than 65% in one day and much to my disdain he is seriously considering taking the rest of the summer off.

Waiting for Godot?

Market is getting bored of waiting for the US congress to come up with something viable. It's starting to feel a little like Samuel Becket's play (on a separate note I've forced myself to see various production of it over the years and only managed to not leave after the intermission on one occasion).

I'm packing at the moment for a weekend away in a warmer climate! I hope we will have something on the table by Monday.

when will the money run out?

A week later, we are still here - no progress has been made in the U.S. debt ceiling discussions as best we can tell and the house should be voting on their plan tomorrow with the senate later in the week. However a new twist has been brought to the story. Based on the latest numbers, the U.S. treasury managed to find a lot more cash in their back pockets, sufficient to allow them to get by for at least another week. Then the money REALLY runs out.

I doubt this is really something the Treasury wants to shout from the rooftops, as it would take the implied pressure off of the two sides that will ultimately need to do the unpleasant task of compromising. I was secretly hoping that the market would have been uglier yesterday to put a bit more pressure on Congress, but that failed to happen since everyone has been looking for a last minute agreement all along and remained unfazed (or sleeping on a hot summer afternoon?!). I imagine at this stage, both parties, surely aware of the new found leeway, are even more likely to hold out for a deal on their respective terms.

So what happens as the 2nd of August deadline passes? The risk of a downgrade would be raised even further. I've always thought of rating agencies as being completely rubbish but I would still hate for the US to be stripped of their triple As. I fear a big selloff in treasuries as well as equities in this scenario so I have decided to put on some protection, mostly in the shape of put spreads on the US contract with a September expiry. I'm short the higher strike and long twice the lower strike generating a small overall cost. It carries negatively as all outlier trades do but it's a small cost I am happy to bear, for now.

Good luck and have a good week ahead.

the debt ceiling situation

Complete lack of economic data today lead to some super quiet trading hours. I struggled to find liquidity even in the most straightforward treasury market so I had to look for other ways to entertain myself.

All eyes remain on the debt ceiling fiasco. I for one don't believe for a second that there is any real risk of default. However with Moody's and S&P's repeated warnings about a potential downgrade of the U.S. credit rating, the entire issue seems to be taking a decidedly more volatile turn. Now a default would be an event but a downgrade is something based on probability not events. With each passing day, where the two sides are bickering and competing on who can throw more toys out of the pram, the probability of a downgrade increases steadily. So many deadlines have passed that I can hardly remember when the next one is. Nevertheless one would be right in thinking that we need a breakthrough by the end of this week to allow just a little bit of time for legislative procedures.

I've decided to sit relatively light for this week with a small short gamma position. You see I have faith:). In the event of a downgrade I would imagine an initial massive sell off of US treasuries, accompanied by an even more humongous sell off in equities, at which point things become extraordinarily messy. Investor would invariably recalibrate their risk appetite in such an event and very possibly move away from the stock market to return to the treasury market as the latter is perceived as the "lesser of the two evils". It's late and I'm not completely sure if this logic is somewhat flawed. What are your thoughts?

Hank Paulson in aviator shades :)

Just came home. I'm way too tired to write anything meaningful so just a photo for now. Happy Friday.

the Fed at a crossroad

Plenty of political drama in Europe today that is only rivaled by the daily verbal barrage coming out of Obama's debt ceiling meetings. I was initially hearing that EU leaders are expected to give their approval before next week to a burden sharing agreement with private holders of Greek debt. Later I heard contradictory reports that Eurogroup plans to give Greece enough money to buy back its own bonds in the secondary market at an average of 50% of its face value. This would constitutes as a voluntary haircut and would render the participation of private sectors unnecessary. In any case I see Greece remaining as fragile as ever.

The other big story was Bernanke's testimony which turned out to more balanced than expected. On the hawkish side he seemed to discount the recent rubbish payroll numbers, attributing the weakness to temporary factors. On the dovish side Bernanke did not dissuade notions of further QE or other stimulus. Upon further questioning, the chairman emphasised the same point.

It's fascinating that he failed to rule out QE3. I would see initiating another round of buybacks as being rather silly and this is a feeling probably echoed by many. This time last year I asked Alan Greenspan in casual conversation whether he thought there should be any monetary stimulus at all and he gave a resounding no. last week I saw him again in Aspen. He laughed when I brought up the stimulus topic and he implied that the QE2 was rather pointless and unfortunately I agree. QE1 and 2 spent over 1.3 trillion USD and apart from inflating asset prices, I'm not sure it managed to achieve a whole lot more. The unemployment rate failed to fall in any meaningful manner so the message is there.

what's happening to the second i in PIIGS?

I was mostly absent from the market last week and coming back today turned out to be a bit of a nightmare. One of our main trading systems failed first thing in the morning and after numerous vain attempts to fix it, our IT decided to restore the entire file system from tape with an estimated completion time of 6 hours.

Everyone was in utter disbelief! I could not see the risk on my book, and had no access to my pricing system. It's practically like a blind person swimming in the dark sea at night alongside a group of sharks. (to be fair, when you are swimming with sharks, whether you are blind makes relatively little difference) I decided that less is more and managed to do as little as possible for the majority of today.

On the PA side, the risk situation is much clearer:) -  I have mostly been keeping a small short EUR position. While the US could be in better shape, the Eurozone continues to do an excellent impression of a deeply wounded organism entering its terminal phase of dysfunctionality. Greece is still in hot water but the hedge funds have moved on - Market seems to have decided that for the next stage of the peripheral punishment, all roads lead to Rome. With the 5y Italian CDS reaching its historical high, the second i is back in PIIGS. Personally I have a lot more faith in Italy - the country is not suffering from a burst property bubble, balance sheet restructuring or massive cuts in public spending. I'm not particularly biased even though I did spend a small but wonderful part of my childhood living in Italy. One thing worth noting is that a large proportion of Greek debt is in foreign hands. This gives rise to an obvious problem as foreign investors tend to pull out of a country a lot more quickly when "sh*t hits the fan". In Italy over half of the government bonds are actually held by the Italians. In any case I aim to take profit when EURUSD is around 1.4000.

Have a good week ahead and good luck.