E-piphany

Going into the weekend, markets were recovering somewhat on optimism as German Chancellor Merkel had signaled in a meeting with French President Sarkozy a “compromise” on the role of bondholders in the rescue of Greece. However, the ECB had not indicated any compromise, so unless Merkel was prepared to cave in and hand over German taxpayer money – which would probably mean the end of her tenure – it wasn’t exactly the same as a resolution. The ‘rollover’ strategy she was said to favor was what the ECB specifically had said they would not participate in and the ratings agencies had already said would constitute a default, so it didn’t really seem like a resolution except to true optimists.

From a trading perspective, the market reaction on Friday indicated that investors are looking for good news or anything they can characterize that way. A fear of being short or not long enough was starting to outweigh a fear of being too long and exposed to risk assets.

Over the weekend, the “deal” came unraveled a little bit when the Euro-area finance ministers (including those from the other pesky countries that have to unanimously approve any further disbursement) failed to decide in favor of releasing the July tranche (some $17bln) to Greece.

And yet, the positive vibes continued on Monday. This is worrisome, because it seems that investors almost want to be surprised by what is the increasingly-likely outcome of a Greek default (although not necessarily in July!). By trying to catch the zig-zags, I fear that investors are setting themselves up to be bag-holders once the exit door grows small once again.

Example: “Looking at the consequences of not funding Greece, they will do it”…said someone who helps manage $15bln or so at a big money management firm, according to a Bloomberg story. This is a naïve view, and represents what has passed for analysis for a long time. You were safe investing in Citi during the crisis, because “surely they won’t let Citi fail.” They’ll save Greece because the consequences of not saving Greece are too terrible to contemplate…or so the reasoning goes.

But that’s the wrong question. Surely if saving Greece was costless, everyone would agree to do it. There are costs, though, and so the better question is “are the costs of saving Greece worth it, not to the wealthy managers of $15bln but to the people who actually have to bear those costs, the taxpayers and shareholders of banks and citizens of wealthy countries?” This is where the process is breaking down a little bit, because some groups are starting to question whether saving the grasshoppers is really in the ant’s best-interest. Of course, the ultimate question is, “is it possible to save Greece?” As much as we would love to save everyone who ever had any financial difficulty, it simply isn’t possible. Long-time readers know that I am loathe to discount the survival meme among institutions and political systems, but these are the more-interesting questions right now.

John Mauldin’s newsletter last week raised the question “Could the Eurozone Break Up?” Again, it’s the wrong question and reflects a status quo bias. A fairer question is whether the Eurozone can possibly stay together!

By the way, I want to raise a logical inconsistency in the whole Greek deal that began to bother me on Friday. The discussants in the “bailout” talks are intent on making sure that any resolution that involves extending or rolling the Greek debt will not “count” as a restructuring or default event. This is now completely necessary since the ECB has drawn a line in the sand with respect to defaulted securities. That line can be erased, if the ECB is willing to lose face; and if the EU is willing to change the rules again so that all sovereign bonds even if in default can be carried at par that can be done as well. Sure, that would make a mockery of bank capitalizations but it isn’t without precedent (except at this scale).

But let’s suppose all of those hurdles are crossed. The question is, why would a creditor to Greece agree to take an economic loss in a way (via a ‘voluntary roll’) that prevented his hedge from being triggered? After all, while it is popular to think of credit default swaps as being evil tools of speculators and bear-raiders, in reality they are very useful hedging tools that are widely used by legitimate investors. Causing a non-default default would punish those investors who held onto their Greek positions, but hedged them. For those investors, the worst possible case is that Greece effectively defaults – that is, they experience a big economic loss through a restructuring or ‘voluntary roll’ – but the value of the hedge goes to zero. Why would those investors, which will include some banks, pensions, and investment managers, ever agree to a roll? Such a resolution is not “better than the alternative,” but actually worse than a default which is actually called a default.

It isn’t clear to me that the desires – and the votes – of this constituency have been considered. How can any ‘roll’ be considered voluntary if some class of investors is screaming about the injustice of the outcome?

In my view, the most-likely case continues to be that this all ends up with monetization by the central banks. I don’t see any reasonable outcome from the Greek (and to a lesser extent, the Irish and Portuguese) situations that keeps these countries from defaulting. And I don’t see any way for Greece to default – whether or not it is called a default – that doesn’t result in massive trauma to the international banking system – whether or not the bonds are carried at par or not. And I don’t see any way that massive trauma to the banking system can result in anything other than another credit crunch and an eventual monetary response. While calling a triple-combination is no less challenging in economic forecasting than in billiards, this seems inexorable to me and only the timing in question.

Interestingly, the inflation markets are also acting optimistic on the general pricing environment. While both real and nominal interest rates continue to drift to ever-lower levels (generally, although not today), the implied core inflation has remained surprisingly static as well as high compared to the current level of core. The chart below is an updated version of a chart I have run before. It illustrates that the sharp decline in 1-year inflation swap quotes is mostly explained by the drop in forward energy prices. The red line is the 1y inflation swap; the other line is the residual after subtracting out the movement implied by energy futures.

Plummeting inflation swaps quotes does not imply a change in the view on core inflation

If investors were seeing a disinflationary impulse in our future, surely this would show up someplace other than in energy prices only.

Still, inflation swaps are getting more attractive because as energy prices drop it creates another way to make money on a long position in swaps or breakevens. At $120 oil, you could be long core inflation but were very exposed to a growth-related drop in energy quotes. At $93.50, this is a smaller risk.