Wednesday, November 9, 2011

Italian Job

Although I believe that there should be some more runs in this bear rally (see my earlier post on Oct 12 of Bear Rally), now it may be a time to start to be vigilant and set one foot out of the door (or the finger on the trigger) to sell the risk trades whenever necessary. The market indexes are already close to level that I would feel comfortable given a margin of safely. But more importantly, Italy is the elephant in the china shop that the markets do not seem to see; it will be an Italian job to crash this party of bear rally. The yield on Italian bonds finally crossed 7%. Yet that is not the problem; this level of yield by itself would not necessarily lead to an immediate crisis. Yes, Italy has over 3 trillion Euro of debt, but the average maturity is about 7 years. So unless there is some urgent refinancing need, the yield itself does not cause any real problem. But if this level of yield is sustained for quite a while, there is no question we will see the end of Eurozone in the current form. 

So what are the solutions? The easiest solution is to have ECB buy an unlimited amount of Italian bonds. As a central bank, ECB has the obligation to do that, and this lender of the last resort is an effective tool to prevent banking crisis. Or Eurozone would have fiscal union. The two solutions are effectively the same, because the first solution would require eventual fiscal union to backup ECB. So the first solution is just to buy a bit more time before the final solution. Anything short of these will lead to the end of Eurozone in its current form.

But ECB is shirking from its obligations. Instead it is arguing convolutedly that it does not have this obligation (there is some hope that it will shut up and do it after a fair amount of crisis). Germany has eaten the cake of free riding the demand of other Eurozone countries, mostly PIIGS countries, in the last decade, and now it still want to have the cake too by asking for the full pound of flesh: all the money that it shoveled to PIIGS countries for them to buy German goods in the last decade. This is impossible, and will only lead to the end of Eurozone.

So investors should be on heightened alert (not necessarily actions yet) if they still want the limited percentages left on the table or they should retreat from their risk trade if they would rather have a more peaceful mind. From now on, the upside to volatility ratio will be much lower than what it was in the last month.

Would Eurozone by salvable? Yes, of course, contrary to many naïve perceptions even by professional investors. On a whole, it has few problems. Its debt to GDP ratio is reasonably low; it has little current account imbalance with the rest of world. All the imbalances are within its border. The sum of the current account deficits from PIIGS countries are almost exactly the same as the current account surplus of Germany over the last ten years. Overall, it is in the best shape currently in comparison to the U.S. and China. Its productive and intelligent people (as individuals, not government) always impress me (especially the Germans). It is a pity to see it being destroyed mainly by German Stubbornness (well they are famous for it). Note even if this case, Germans would not get a tiny bit more: these countries will leave Eurozone and default, thus bankrupt German banks. In addition, through currency devaluation, they will gain competitiveness overnight and Germans would lose its export market anyway. If you do not believe it, look at historical data; before the creation of Euro, most PIIGS countries never run chronicle current account deficit.

Why is that, you may ask? The reason is because once countries are in Eurozone, they have convertibility and stability of their currencies (which all become Euros), while losing independent monetary policy (interest rates) according to the impossible trinity. The fixed exchange rate with Euros also means they lose the important channel of (re-)gaining competitiveness through currency devaluation. It is way easier to gain competitiveness through external devaluation (exchange rate) than internal devaluation (cutting jobs and wages). When ECB set the interest rate according to the core/Germany, which is the main part of Eurozone economy, at a level that is too low for PIIGS countries, those countries experienced growth/housing bubbles on steroids (low interest rate). Investors’ expectation of eventual fiscal union within Eurozone also gives them false comfort that drives the long term yield of PIIGS countries down substantially. After the growth/housing bubbles collapse, along with the U.S. housing bubble, PIIGS countries’ economies are in shambles and their risk premium goes way up. The core countries also make sure that investors now realize the fiscal union may be just a wet dream, which pushes the long term yield of PIIGS countries even higher.

It is absurd that Germans are asking the pound of flesh. Any fixed income investors, a.k.a, creditors, are on the hook to evaluate credit risks before parting with their money. Once the money is parted, and the borrowers can and have the natural right to default. In defaults, the creditors are the ones who should be blamed, for being negligent about underpricing credit risks, instead of the debtors (This same absurd thing is also happening in the U.S. when zombie banks do not let go homeowners who would default).

It is also absurd for Europeans to ask emerging countries like China for rescue funds. They can rescue themselves easily; why ask anyone else. Further, have a huge amount of capital inflow from China would require a nearly equivalent amount of current account deficit against China, as required by the balance of payment identity (in a simpler form, it can be written as current account balance + capital account balance = 0). That would be a huge boost of employment for China, and condemn the PIIGS countries to eternal pain of soaring unemployment.

The bigger imbalance is between the U.S. and China. It would be an even more interesting show to watch how that would resolved. There, it is unlikely that China would have the political and military might to impose its will on a still superior U.S. Unless the U.S. is silly enough or being drugged by the currently evil republicans to do what PIIGS are doing (following German orders to give the pound of flesh), it is likely that China will face even worse outcome than Germany in that bargain. 

In sum, be on alert to get out or lighten up on risk trades soon.