Dumb and Dumber
Source: David and Eric Coffin, HRA Dispatch (8/12/11)
"As Europe were pouring oil on the waters, Washington was busy adding gasoline to the flames. All this drama is not making any markets happy other than those for gold and the Swiss Franc."
The new plan does imply a haircut for private lenders in the order of about 21%. This seems more than fair since the odds of these bondholders seeing 100% directly from Athens are slim and none and everyone knows it. Of course, this decision led to another ratings cut on Greek debt from "junk" all the way down to "what the heck is that smell?" The rating cut is simply more after-the-fact behind-covering and no surprise to anyone, though it may roil the bond markets in Italy again.
There are an increasing number of calls for the ECB to issue some sort of umbrella EU bond backed by all member countries to replace high yielding paper of the peripheral countries. If this sounds suspiciously like the U.S. Fed printing money that was passed off to the states to cover state and municipal shortfalls in the past couple of years that's because it is. This solution would create another political dogfight between the spendthrift south and fiscally responsible north in Europe. It would also be kicking the can much further down the road and would work for a while at least.
Like the U.S. Dollar, the Euro has hardly been punished in the past few months, given how serious the fiscal situation is. Bond rates of the core countries have barely budged, even though it's obvious to all who will have to foot the bill at least in the short- and medium-term. That is because the market recognizes that, viewed as a single economy; the debts of the PIGS (sans Italy) are quite surmountable for the EU block. The real question is the willingness of core countries to take the proverbial bullet on this one. If they do, it will be for the same reason Washington took the bullet in 2009; fear of a systemic breakdown.
An EU bond plan would require a basic change in the philosophy behind the European Central Bank. The ECB would morph from guardian of price stability to being guardian of financial system stability. This would not be a comfortable change and would be fought hard in most of northern Europe. The ECB buying up high yield debt to replace it with some new EU bond would be money printing, but would also have the advantage of creating another deep and hopefully liquid market to rival the U.S. Treasury and Japanese government bond markets.
This would be a good thing longer term even if creation of the bonds themselves isn't. The world's number one and three economies manage to maintain fairly stable interest rates in the face of huge public debts in Japan and political one-upmanship in the U.S.. There is a lot of money in bonds and it gravitates to the most liquid markets in times of stress, even when they are the cause of the stress. A pan Europe bond would finish the third leg to the currency stool the Euro alone didn't quite do.
The EU bond is a long way from being reality, but we won't be surprised to see this idea gain traction. We don't like the moral hazard implicit in this concept but it may yet be necessary. There is no reason a plan like this couldn't entail losses for current bondholders the way the latest Greek rescue is supposed to. It should. These rescues have always been about protecting EU financial institutions as much as anything. Less dithering and a more final solution would be best but it could and should mean real pain and maybe bankruptcy for the most incompetent institutions. As long as the market viewed it as punishment fitting the crime and there was an umbrella guarantee that precluded a domino effect it should work.
This is not dissimilar from TARP. For all the moaning and wailing and gnashing of teeth over that program it looks like it should wrap up turning Washington a small profit. The same thing should be possible in the EU if banks were forced to give up equity stakes as part of the bond buyouts. Whether the ultimate creditors (citizens of the PIGS countries) should get off is the real and thorniest political question but one that can be argued after the system is stabilized.
As the Europeans were pouring oil upon the waters, politicians in Washington were busy adding gasoline to the flames of their own conflagration. The situation in Washington is really less serious by any objective measure but you wouldn't know it by listening to the increasingly shrill debate.
Politicians on both sides of the House are acting like increasing the debt limit is drama never before seen. If only. The debt limit has been raised seventy times (that's no typo) in the past fifty years and ten times in the last ten. It's an annual display of cynicism by politicians of both parties that have already voted spending bills that will breach the existing limit. And don't think those spending bills all originate on one side of the house. Europe may have the PIGS but Washington has no shortage of pork in all political stripes. This year is different only in the level of intransigence being displayed.
As this is written, we're a week away from the U.S. having to shut down programs. This is not a once in a lifetime event either. It happened in 1995 when Bill Clinton and Newt Gingrich sparred over the deficit and the debt ceiling. There was no "default" but government services and entitlement payments came to a halt. The situation will be similar a week from now if politicians continue to choose melodrama over common sense.
What is different this time is that rating agencies (yes, them again) are threatening to cut ratings on U.S. debt if an agreement isn't reached before August 2nd. A change in rating could be long term, but probably not permanent if reasonable deficit cutting plans get agreed to and are actually stuck to. This too is not the end of the world, but it would be a shock to markets and would raise U.S. government borrowing rates across the board. A ratings cut of 2-3 notches might add half a percent to borrowing costs. Not chickenfeed on $14 trillion in debt but not Greece either.
If August 2nd passes without an agreement the Treasury would have to match expenditures to revenues since additional debt could not be issued (existing debt could be rolled over, but the total could not get larger). Given the large mismatch between revenues and expenditures in Washington this year the cuts would be large and painful until a new agreement was in place.
Expect more and perhaps larger swings as each side of the debt debate ratchets up the rhetoric in coming days. It may already be too late to forestall some interruptions in benefits but we're pretty sure the sun will still come up on August 3rd even if there is no deal yet. We note again that if one looks to the debt markets there is no sign of panic. U.S. 10-year yields are barely above 3% and two year yields are sitting near 0.5%. Credit default swaps on U.S. government debt are priced at 0.6% which tells you that even at this point bond traders see default, as they define it, as a very low probability event.
Maybe the traders are just being overoptimistic but the bond market has a pretty good track record for sniffing out problems before the equity markets figure them out. It's all politics now and bond traders seem to be going out of their way to ignore it unless they are already largely and publicly short the Treasury market.
All this drama is not making any markets but the ones for gold and Swiss Francs happy, and we doubt the Swiss are pleased about how high their currency is trading. Gold continues to make new highs, but traders are cautious about gold producer stocks. There is worry, justified we think, that this is a fear buying spike that would at least partially dissipate as soon as the two sides in Washington reach an agreement. We wouldn't expect to see gold producers respond strongly to higher gold prices until there is a debt agreement and traders are comfortable short term money parked in the gold market has left.
That's not to say the gold price would see a long term top at that point, nor that gold producers as a group would continue to languish. A currency alternative without squabbling politicians attached to it has taken root as a concept and gold is part of that.
Juniors are faring better, and companies delivering good results are getting traction, particularly in the precious metal space. The Yukon continues to gain traction though there have not been many news releases recently. We would stick to those companies with the caveat that a resolution to the U.S. debt issue will probably mean at least a temporary pullback in gold prices.
More economically sensitive issues (think iron ore, potash and base metals) could be good for stink bids but we would wait to see if Washington actually grinds to a halt before placing those. The ultimate impact on the world's economy shouldn't be anywhere near as dire as politicians are making it sound so the most pro-cyclical names could be the best buys if the markets do freak out next week but you may as well wait to see if it happens at this point.
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