Wednesday, April 3, 2013

It's The Economy Stupid: Zervos' Risk-on-Hold

Ya just gotta love the way Zervos writes.

-----Original Message-----
Sent: Wednesday, April 03, 2013 10:31 AM
To: John Broussard
Subject: Risk-on-Hold

For the last couple weeks we have stepped away from our multi-year risk-on views. The news in Cyprus was enough to temporarily change the game. And while many folks have questioned our HIGHLY unusual bout of nervousness over such a small country, I suspect that once we see the long term fallout from this crisis materialize, there will be little doubt that the actions of the European leaders towards Cyprus will have fundamentally changed investment risk premia both in the Eurozone and in global markets.

Just threatening to impair INSURED bank deposits will create a lasting psychological scar for the weakest links in the European banking system. To even suggest such a draconian move shows a complete lack of understanding of financial markets. And forcing losses on uninsured depositors will forever change the funding costs for even the most healthy of European banking institutions. Back in the heat of the battle, during the S&L crisis in the US, uninsured deposits were ALWAYS made whole. FSLIC went bust, and taxpayers were forced to pay, but deposits were paid. Banks are the life blood of any financial system, and threatening the basic backstop of deposit insurance will generate serious unintended consequences.

Of course the world will survive without Cypriot banks - and probably without much of the unnecessary banking systems in the south of Europe. But the template of Cyprus lives on. Actually, I like to think of it less as a template and more as a disease - maybe we call it Cyphilis in keeping with our theme last week that "we might have an STD situation brewing". As with any STD (sell the dip) situation, we should naturally expect the Dutch to be the leaders in spreading it around (enter the new Eurogroup leader). But as we sit back and reflect on the Dutch spreading Cyphilis throughout Europe, it is important to understand that it is curable. Mario's balance sheet full of antibiotics will make it go away. However, we need to make sure the doctor chooses to work his magic. And right now, the ECB balance sheet ain't moving!!

The most disturbing part of the last 2 weeks is that European leaders have gone back to their old and nasty ways of solving the debt problem - using default and private sector loss. This is a dangerous turn of events. They are re-introducing Cyphilis to the system because it makes for good politics.

Since the Lehman brothers default, the debt problems of the US and Europe have largely been solved by pumping money to the system. Throwing money at the problem - via central bank balance sheet expansion - surely created some longer term inflation risks, but it importantly stopped the threat of a debt/deflation spiral. Ben realized (post Lehman) that we were flirting with a debt/deflation spiral in the US, and he snuffed out that risk with ever increasing doses of monetary accommodation. At the same time the Europeans embraced a default mechanism back in Deauville in 2010. And while "making the bad guys pay" wins some votes, the ensuing Cyphilitic disease becomes an unwieldy solution to the debt woes. To that point, as the default risks escalated and "oozed" through the Italian, Spanish and even French debt markets in 2011/12, the ECB was forced to act. It became painfully clear that introducing Cyphilis to solve a debt problem generated serious systemic rashes/risks. The Union was on the brink of disaster numerous times as the default policies of Deauville were implemented. In order to avert complete catastrophe, the ECB was constantly forced into expansionary policies via the SMP, OMT and LTRO structures. Eventually the Europeans had to throw money at the problem just like the Americans or risk a complete systemic breakdown. Eventually they did the right thing.

Of course we all know there are 2 ways to solve a debt crisis - throw money at the problem and use inflation to devalue the debts; or, don't throw money at the problem and allow mass default to reduce amount of debt in the system. Policy makers can use the inflation solution and risk an outcome like the 1970s, or they can use the mass default solution and risk an outcome like the 1930s. Neither is particularly nice, but there is no easy way to escape a debt crisis - that's why it is called a crisis in the first place.

One must pick the lessor of two evils. And it has been our baseline argument for many years that Ben has correctly taken the inflation risk solution over the depression risk solution. In Europe however it remains to be seen what they choose. Each time the ECB balance sheet expands and it looks like they are headed in the right (inflationary) direction, we get another swerve back towards the 1930s. Cyprus is exactly that - a move towards a chaotic and systemic solution for the European debt crisis.

And whenever we see policy makers veer away from balance sheet expansion, money printing and inflationary policies we should become nervous. There is too much bad debt in the European and US markets. And allowing the template of mass default back into the system should raise risk premia. Of course Mario will most likely be forced to inflate if things get properly messy, just has he has done before. But with markets at the highs, and no dips to buy, the prudent trade is to stay with those hard won risk chips off the table. Sadly, the Europeans are back to playing dangerous games, and it is best not to engage with them when their Cyphilis flares up.

As we mentioned last week, Euro downside and Bund upside are worth a shot here - and those trades have worked just fine. But its still a "Risk-on-Hold" world. In the end, let's hope the Dutch fail at spreading Cyphilis and Mario breaks out the penicillin soon. It would be nice to get back to our happy world of spoos and blues or Nilkkei and blues. Unfortunately, for now, the short term risks simply outweigh the rewards for those wonderfully back stopped long term trades. Good luck trading.

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