The combination of political deadlock in Greece and the fact that the European Financial Stability Facility (EFSF) will be funded by debt and not money printing has caught investors off guard recently. They failed to discount the ability of politicians to find other options in their attempts to exhaust all other options before turning to the inevitable one. Hence the falling markets of late.
The largest risk to these forecasts is the sovereign debt and banking problems in the euro area,
….The Bank’s central scenario continues to be one in which the European authorities do enough to avert a disaster, but are not able to avoid periodic bouts of considerable uncertainty and volatility. A worse outcome in Europe would adversely affect the Australian economy,…
Louise Bowman explains at Euromoney the sort of thing these people come up with to try and solve the crisis:
‘If one were tasked with designing a CDO that would be guaranteed to fail it would be hard to come up with a better structure than what the EU is proposing for the EFSF.’
Now Wall Street, to the small extent that it is still capitalist, has wound down many of the ridiculous practices of the boom years. Like issuing CDOs doomed to fail. But the politicians have other ideas. They want to use those very practices to bolster their bailout fund, the EFSF, to size.
It reminds us of this quote:
‘The central irony of financial crisis is that while it is caused by too much confidence, too much borrowing and lending and too much spending, it can only be resolved with more confidence, more borrowing and lending, and more spending.’
Former US Chairman of Economic Advisors Larry Summers
That’s not irony. It’s a number of other things we won’t write.
So the MEPs and their friends are off on a mission to create a bailout fund they call the EFSF. They want more confidence when there is too much. They want more borrowing and lending when debt is the problem. They want governments, on whose payroll MEPs are, to be able to continue running deficits. And they are going to achieve these noble goals using the same method that triggered the financial crisis of 2008. More of what Larry Summers calls ‘irony’.
There is an even more groan-worthy aspect to this. The EFSF will use credit default swaps (CDSs) to guarantee some percentage of some countries’ sovereign debt. If you missed Wednesday’s Markets and Money, CDS have been called into question, to put it lightly, by their failure to protect Greek bondholders from the 50% haircuts.
In other words, they don’t work. Just another ‘irony’ of the plan.
These kinds of political and legal shenanigans simply outweigh the effects of economics on the markets in the short run. The bi-polar nature of politicians is turning markets bi-polar. Our trading analyst Murray Dawes of Slipstream Trader fame reckons it’s nigh untradeable. For now.
But the laws of economics always win out over CDOs, CDSs, EFSFs and the rest in the end. The last act of desperation by those who see themselves as ‘in charge’ of the economy will be a flood. In central banking terms, that means a flood of cash. This is probably what markets are discounting – a snazzy way of saying they include it in their forecasts. It’s the reason they haven’t truly crashed. Money printing inflates stock prices too.
But those of you two steps ahead might notice that the debt the EFSF will issue in its attempt to resemble a doomed CDO is just the kind of debt that central banks like to buy. And are authorised to buy. The Germans, by allowing the creation of the EFSF to buy sovereign debt and by allowing the ECB to buy the debt of the EFSF, may have been skilfully outmanoeuvred in their quest to prevent true quantitative easing in Europe.
If you’re confused, you’ve got the gist of it.
We’ll try and overcome the confusion with a little creativity. The dialog of the past few weeks might have looked a little something like this:
PIIGS: The ECB should buy vast amounts of Portuguese, Irish, Italian, Greek ,Spanish (PIIGS) debt to solve the crisis.
Germans: Nein! Inflation! Weimar! Hitler!
PIIGS: Then we should create a bailout fund.
Germans: Hmmm, OK.
PIIGS: The bailout fund isn’t big enough; it needs to be able to borrow money.
Germans: Hmmm, our constitutional court says ‘Nein!’ … but OK.
Investors: Go kiss a Koala! We’re not lending your bailout fund money. It’s full of sovereign debt we wouldn’t buy, guaranteed by CDSs that don’t work and looks like the CDOs that blew us up in 2008.
Everyone: Uh oh!
(From this point on, we are speculating as to what will happen next)
PIIGS: ECB, ECB, wherefore art thou ECB?
ECB enters on white donkey, stage right
ECB: Don’t worry, we’ll save you! Here, have some fresh cash we just created.
ECB hands out cash to the PIIGS. Then the sound of a helicopter is heard and it begins raining US dollars
Federal Reserve Chairman Ben Bernanke: Take that deflation!
Germans: Woe is us. We should’ve known PIIGS will be PIIGS. We should’ve known not to trust a Frenchman and an Italian to run our central bank. We should’ve known the Fed would intervene. It’s time to get out of the Euro before we pick another fight.
Shakespeare might not approve of the script. But reality is said to be more entertaining than fiction.
So yes, we still expect more quantitative easing and high inflation to make an appearance at some stage.
But the conclusion you might want to reach in this period where political uncertainty dominates the market, is to avoid complexity in your own investment decisions. Don’t depend on legal definitions, especially ones that are easy to change. Give as many middle men the boot as possible. Sometimes middlemen introduce more risk than they make up for in convenience.
This may come a little late for about 8000 Australian CFD users, after their broker MF Global found itself on the wrong side of the sovereign-debt trade. But the point is that the uncertainty caused by political uncertainty has a different nature – and sting to it – than the economic uncertainty that investors are more used to facing. Don’t get tangled in it.
These are (some of) the reasons why the Markets and Money likes physical gold in wealth portfolios. It has no middle man and no counterparty. It’s yours if it’s yours. And, short of messing with the periodic table or new developments in alchemy, governments can’t do much to mess with it.
More on that next week…
Until next week,
Markets and Money Weekend Edition