July 13th 2012Fasanara Capital | Bi-Weekly NotesWith the anti-spread device introduced earlier on this month, the ECB attempts at manuallyremoving a major catalyst from the market, yet again. The list of centrally-plannedbackward-looking ‘manual removals of catalysts’ along the way gets longer and longer. Atthe end of last year, it was wholesale Dollar financing for European banks (as reflected byeurusd currency basis) and central banks reacted with unlimited $ liquidity financing.Shortly afterwards, it was bank’s liquidity and inter-banking financing (as reflected by OIS-Libor spreads) and the ECB reacted delivering the LTROs. It was then about financing forSovereigns (as reflected by spreads to Bunds and absolute yields) and the ECB reactedmaking those same banks buy local government paper. Now, the banks dry powder forpurchasing government securities has evaporated, with spreads rising again to crackinglevels, so the ESM/ECB have reacted with attempting to manually cap them via the anti-spread mechanism. We expected the ECB’s SMP operations (as opposed to LTRO) to beutilized as best bang for the buck, and this device is just a substitute for it (and a weakerone). From here, we expect the next potential catalyst to be bank capital, in addition tobank liquidity, and we may see the ECB moving from LTRO and SMP to larger AssetPurchases programs (TARP-style), at some point this year or next, to replace over-valuedassets with cash and capital at an inflated bid. Listening carefully to Draghi’s own words lastweek may make it transpire.Two immediate consequences can be expected on such ECB’s crisis resolution policies.Firstly, incidentally, you may have to wave bye bye to the traditionally-shaped distressedopportunity in Europe, executed via fire-sales from banks’ balance sheet, as it will bepostponed yet some more. Our own conversations with banks these weeks point in thatdirection. Forcing market participants like us into unconventional ways to play on that table,as we believe there are still mechanisms to capture that value. Secondly, this course ofaction will also lead to a more meaningful side-effect, in preventing or further postponingthe full disclosure of losses, ring fencing of bad assets, the removal of such bad assets andinsolvent institutions from the system and the subsequent recapitalization of viable(illiquid but solvent) institutions; thus critically missing key commonalities to previoussuccessful crisis economics: resoluteness, transparency, removal of uncertainty. All in all, a
multi-year period of slow deleverage, prolonged stagnation and system-wide forbearanceseems more likely than a quick recovery of some sort (and therefore remains the centralcase scenario under our Multi-Equilibria market theory). This also means that, as it standsright now, in the intentions of policy makers, a Japan-style outcome might be the mostlikely and luckiest one for Europe.More generally, the common denominator of such reaction-only ‘manual removals ofcatalysts’ policymaking seems to be adding new debt on old debt, leverage expansion ofthe public sector to avoid a disorderly deleverage in the private and public sector,transferring the costs of the crisis to the future, and to still unaware taxpayers and EURholders. As opposed to face reality and tackle the overleverage with financialrestructurings/rescheduling/haircuts and the likes (which we have so far seen only inGreece’s and Ireland’s PSIs, while having helped fix Sweden’s quick recovery in the early90’s). Financial engineering on the balance sheet of the ECB , leveraging banks’ balancesheets to buy government paper, crowding out the private sector and killing tradingvolumes to un-precedent levels, soon replacing banks assets with brand newly printed cashfrom the ECB itself, are all ingredients of the same debt-laden intervention policy.Such behind-the-curve policies may work as long as one specific segment of the economyreaches its tipping point, when it breaks out and calls the bluff. Over the course of theeconomic history of previous bubbles, a coveted asset is the object of speculation, typicallyReal estate/housing/equity, rising above its fair market value, helped by credit expansion/easy credit, until it busts and ignites deleverage. Perhaps, given the institutional sovereignand supra-national players involved, this time around the coveted asset may be debt itself,debt on debt, as an addictive compulsive behavior with inevitably diminishing returns overtime and larger doses needed next time around, at both the private and public levels, as itrepresents a growingly unbearable share of either GDP, government revenues orhousehold income (which are all declining further as debt grows, under the weight of suchdebt itself, and under the cover of deceptive zero-bound interest rates). Imbalances arebuilding up, as the spread widens and widens between an excessive debt burden and thereal productive economy, industrial output and long-term growth.Interestingly, as too much cash was parked at the ECB deposit facility, last week the ECB cutthe rate of return from 0.25% to 0%, causing a drop from ca. 800bn to ca. 325bn. Time andagain, deceptive zero-bound interest rates are attempting to push risk-off cash into risktaking activities, in sort of a desperate way. Next time Draghi will have to either prohibit
parking cash outright (war-time capital controls) or put a negative interest rate there. As amatter of fact, the ECB’s move has not so far yielded any result, as cash simply flowed fromthe ECB deposit facility (falling from 800bn to 325bn) into the ECB current account (risingfrom 70bn to 500bn), leaving the excess reserves at the ECB broadly unchanged (at 780bn).To be true, we do not dispute that the ECB, and global Central Banks in general, havemore bullets at their disposal. We are convinced that they do, and may be in a position touse it, with the appropriate political backing behind it. Expanding their balance sheet by anadditional 20%/30% is a possibility, in our eyes. In fact, we do expect a reflation to newhighs following decisive Central Bank activity at some point over the next few months(especially should the market correct markedly and spur panic). However, we are doubtfulthat they will be surely successful in doing that, as the market is currently pricing in, on ourcount. After all, central banks’ balance sheets have quadrupled over the past five years. Thetwo key questions on investors’ minds should be: why haven’t they then sorted it out bynow? Can they quadruple it again over the next 5 years?Differently than other market players and observers, we doubt that the latest round ofpolicymaking has bought much time. Actually, we believe the next 6 months will be will bekey to assess the probability tree diagram around potential outcomes, and mayconsequently represent the most interesting window of opportunity for our Fat Tail RiskHedging Programs.The main checkpoints on our count are the following: (i) Germany: from here, it will beinteresting to see, whether Germany will allow its Target2 exposure to rise much further.It remains to be seen. If they do, then the trade will be to short them against peripheralEurope, as they will have become, de facto, jointly and severally liable with other Europeaneconomies, on many scenarios. But not as yet. Until then, as explained in our last bi-weeklynote, we retain a smaller (than before) long Bunds RV play. (ii) In southern Europe austerityhas not really kicked in, as yet, and political support is at risk already. What we saw inGreece is still months away in Italy and Spain. Unemployment is there, having prepositionedat dangerous levels (52% youth unemployment in Spain, 36% in Italy, and rising), waiting toreact to the full wrath of such austerity measures. In Italy, domestic support seems to berapidly evaporating. Spain too is dangling on a string, with 52% youth unemployment,ever-falling real estate valuations and deposits on a steady decline.Where we watch such key vulnerabilities playing their magic is on the actual money flowsbeneath the surface, as opposed to policy actors’ brave words, and the incidental headlines
that they engineer out of them. Look no further than Eurosystem flows. For instance,money spent by the SNB and the Nationalbanken to defend the Swiss Franc and the DanishKrone against appreciation vs the Euro. SNB has reserves for 60% of its GDP already, havingbought some 50bn Euro while defending the currency floor. Nationalbanken imposed anegative return of -0.20% on its deposit facility. How much more manoeuvringroom/willingness can be left there to defend those undervalued currencies? And the lastcurrency peg under stress, most obviously, is the EUR itself. If history is any guide, threeconditions were met in past currency crisis and emerging market crisis: an over-valuedcurrency (read, the EUR to countries like Italy and Spain), over-indebtedness, as a share ofGDP or the productive economy (rephrased, too much debt and no growth against it), andcurrent account deficit. By any objective criteria, all three levers are met for certaincountries in southern Europe, making the case for a reshaping of the EUR-fixed currencyregime a genuine one. In advanced economies the readjustment may be slower to occurthan in emerging economies (as we learn from the attached interesting piece looking at pastbanking crisis), but it may still do occur over time, including a currency-driven one.Opportunity-SetIn opportunity land, it would be imprudent not to take advantage of such market resilienceto provide one’s portfolio with your own home-made backstop facilities and firewalls, asyou cannot expect Central Banks to do it for you too. In fact, Risk Premia are nowhere nearwhere they ought to be should one factor in the even vague possibility of partially failingEuropean policy making. Our leit-motiv remains to take advantage of current marketmanipulation and compressed Risk Premia to amass large quantities of (therefore cheap)hedges and Contingency Arrangements , thus balancing the portfolio against the risk ofhitting Fat Tail events in the years to come. If we do not hit them, then great, it will be theeasiest catalyst to us hitting the target IRR on the value investment portion of our portfolio(what we call Safe Haven, or Carry Generator). If we do hit one of those pre-identified low-probability high-impact scenarios, then cheap hedges will kick in for heavily asymmetricprofiles (we typically targets long only/long expiry positions with 10X to 100X multipliers).Such multipliers are courtesy of market manipulation and ‘interest rate rigging’ providedfor by Central Bankers. Look no further than that, as we believe that they represent theonly truly Distressed Opportunity right now in Europe. Timing-wise, the next 6 monthsmay provide the most interesting window of opportunity, for theses uses and purposes.
What I liked this weekDenmark to Eurozone: keep your darn euros out. After the ECB set the deposit rate to zero,Denmarks central bank, had to do one better to keep these people out, setting the depositrate to negative 0.2%. Denmarks banks will be losing money on deposits they take in(unless they charge rather than pay interest), which should keep these banks from takinglarge amounts of DKK (converted from euros) from Eurozone depositors. ReadThe Deleveraging Trap ReadDraghis zero deposit rate policy kills euro money market funds ReadJust another scary Spanish capital flight chart ReadW-End ReadingsA recent research from BAML, The Longest Pictures, helps put things into perspective as itcollects the longest series possible for a number of key financial variables. Amongst otherstats, a few numbers captured our attention: (i) 10yr treasury yields are at their 220-yearlows in the US, 140years lows in Japan, (iii) adjusted for inflation, equity markets hadnegative real returns in nearly 1 out of every 2 years since 1871, and after prior secular tops(1907, 1929, 1968, 2000) stocks took 20-30 years to recover back to their previous highs (iii)equities are in their 4th secular trading range, whilst bonds are in their second secular bullmarket: every equity breakout has coincided with a secular inflection in the bond market.The curse of advanced economies in resolving banking crises. The average crisis in advanceeconomies lasting about twice as long as in emerging market economies. It argues thatmacroeconomic stabilization policies in advanced countries often delay the necessaryfinancial restructuring. ReadThe tragic error of excessive austerity Read
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