The Problem with the Euro
Last week I wrote that we could see a drop in the price of oil as speculators seemed to be storing oil in very large tankers and "slow steaming" them to port in a bet that prices would rise. When everyone is on the same side of the trade, the time is right for a reversal. This is especially true when there is a large potential supply sitting on the sidelines.
This week we briefly look at this prediction, and perhaps even more ominous problems for commodities in general, at least in the short run. The new turn our attention to the euro. It will make for an interesting letter.
First off, oil dropped about 4% yesterday and is down almost $10 from its high only a week ago. Yet supplies of crude oil surprisingly dropped by 8.8 million barrels yesterday. Oil shot up on the news as both those who were short covered their bets and even more people piled into the long side of the trade.
But then the EIA report gave the rest of the story. It seems the shortfall "was due to temporary delays in crude oil tanker off-loadings on the Gulf Coast." And as Dennis Gartman noted this morning, "officials at the Louisiana Offshore Oil Port (LOOP) said
that some crude oil tankers cancelled scheduled deliveries last week." The owners of the oil in those tankers are now down about 6-7%, whether it is speculators in the pits or the actual trading companies.
I talked with George Friedman of Stratfor this morning, and he says that the supply of tankers is even tighter, which suggests there is even more oil on the seas looking for a home. Crude oil prices could be under pressure in the next few weeks and months as whoever holds that oil is going to want to get it onshore somewhere and out of very expensive tankers.
Swapping out Commodities
The Commodity Futures Trading Commission announced yesterday that they are looking very hard at possibly closing a regulatory loophole that allowed some extremely large commodity index funds to get around position limits. For those not familiar with the concept of limits, it basically works like this. No trader or fund is allowed to own more than a specific amount of a commodity traded on the futures exchange. This limit varies from commodity to commodity and exchange to exchange. The point is to keep one group from manipulating the price of a commodity, as the Hunts did with silver in the early 80s.
The loophole is one where large investment banks can sell a "swap" for a specific commodity like corn and then hedge their position in the futures markets. There is no limit on the amount of the commodity that can be hedged. So, a fund can accumulate sizeable positions far in excess of what they could do directly by working with an investment bank. In essence, the swap is a derivative issued by a bank which acts just like a futures trade, but it is with the bank as guarantor and not an exchange. Swaps are not regulated as such. And up until now, the banks were seen as legitimate hedgers so there were no limits on what they could buy in the futures markets.
This works for very large commodity index funds which try to mirror a particular commodity index and need to be able to buy very large positions in excess of the normal limits (and there are scores of them), and for the banks that make the commissions and profits on the swaps. Remember, the fund gets a management fee, so growing the size of the fund grows their fees.
These indexes typically have about 26 commodities, with the largest allocation to oil, but almost anything that is traded has some small portion of the allocation. As I noted last week, there are some who believe this is working to drive up the price of commodities beyond the simply supply and demand principles. Whether or not you believe this to be the case, the CFTC is looking at the loophole.
The key word in the announcement yesterday was the word "classification." Right now the banks are classified as hedgers and as such have no limits. But they are not really hedging the actual physical commodity as a farmer or General Mills might do, but the hedge is their financial position.
If the CFTC decides to look through them to the funds, and they did use the word transparency in their announcement, they could decide to change the classification of the banks from hedgers to speculators. While I do no think that might make a difference in the long run, in the short run it could make commodities volatile in the extreme, and exert downward pressure up and down the price curve, depending on how they would decide to unwind the commodity index funds.
For what its worth, I advised my daughter to get out of the commodity fund she was in for the time being. When the regulators are in the room, anything could happen. And they are getting intense pressure from Congress to change the rules. My bet is that the train has left the station and it is but a matter of time until position limits are put in place for commodity funds, including commodity ETFs. Is that a good thing? I think not, but that matters not one whit. The hand writing is on he wall.
Does this mean I am not a long term commodity bull? No, I remain bullish on a host of commodities over the long term from a supply and demand perspective. It is just that you might want to consider whether to stand aside for a time while the congressional elephant is stampeding around the room. Maybe it is a non-event and someone figures out a way to unwind the positions slowly and over time. Maybe the grandfather the current funds at the size they are today. Who knows? As I said, when the regulators are under pressure to do something, I want to know what the new rules will be before I play in the game.
The Euro at Par with the Dollar
About five years ago, I said that the euro, which was trading at about $.88 at the time would rise to $1.50 and then fall back to $1 over the course of a decade or more. It would be one huge round trip. By the way, giving credit where credit is due, that opinion was crystallized over a long dinner with bond expert Lord Alex Bridport and several companions in Geneva. The logic was compelling then and it still is now. We are halfway through that decade long trip and it remains to be seen if we get back to parity. I think we will.
Why would the euro fall? Because the currency is still an experiment in cooperation. At some point, one or more of the weaker European countries is going to need more monetary stimulation than the majority of the countries in the union, for a variety of reasons. Will they pull out to be able to issue their own fiat currency? Will the EU as a whole slow down as the US recovers?
About 4 times a year, I give myself permission to not write a letter, taking a little mental vacation. This week, Louis Gave is graciously allowing me to use a chapter from his latest book, "A Roadmap for Troubled Times" which highlights some of the problems the euro is going to face, as well as analysis on a host of topics.
Gentle reader, this is an important topic and Louis says it better than I can. I highly recommend you get the book and read it. It is only about 200 pages and is a very easy read. The chapters on China are worth the price of admission, as well as his suggested investment themes. You can order the book at Amazon.com.
So, without further ado, let's jump into the problem with the Euro.
The Change In Policy
The Divergence in European Spreads - Why Now?
Back in May 2007, we wrote a piece entitled "Part 2-So What Should We Worry About". In that ad hoc comment, we wrote: "The crux of the thesis of our latest book, The End is Not Nigh, is simple and goes something like this: a) Asian central banks continue to manipulate their currencies and prevent them from finding a fair value against either the US$ or the Euro b) this manipulation triggers an accumulation in central bank reserves which, in turn, leads to low real rates around the world c) the combination of low global real rates and low Asian exchange rates amounts to a subsidy for Asian production and Western consumption d) in the US, the subsidy has by and large been captured by individual consumers e) meanwhile, in Europe, the subsidy has been cashed in by governments whose debt has skyrocketed f) we see little reason why, in the near future, the subsidy should be removed but g) if it were removed, the US would most likely encounter a consumer recession (not the end of the world) while h) Europe could go through a debt crisis (far more problematic)."
We went on and wrote: "Last week, and against most observers' expectations, the Indian central bank did not raise rates at its meeting. Instead, it seems that the authorities are allowing the currency to rise and hopefully thereby absorb some of the country's inflationary pressures (linked to energy and higher food prices). In recent weeks, the rupee has shot higher and now stands at a post-Asian crisis high. And interestingly, the local market is loving it. While Indian stocks had been sucking wind year to date, the central bank's apparent policy shift (from higher interest rates to higher exchange rates) has triggered a very sharp rally.
This of course is an interesting turn of events and we would not be surprised if Asian central banks were to study developments in India carefully over the coming quarters. After all, India is blazing a path that a number of Asian countries may yet decide to follow.
One could argue that a change in monetary policy in Asia could end up being a "triple whammy" for Western economies. It would mean that:
- Asian central banks would export less capital into our bond markets and this would likely lead to a drift higher in real rates around the world.
- Asian exchange rates would move sharply higher, which in turn would likely mean higher import prices in the US and Europe.
- As Asian exchange rates start to move higher, Asia's private savers would likely start repatriating capital, further amplifying exchange rate and interest rate movements. This would also likely lead to collapses in monetary aggregates in the Europe and the US.
Finally, we concluded the paper by saying: As we highlighted in Part 1: Why We Remain Bullish, we are not worried about valuations. And we are also not worried about "excess leverage" in the system, or the threat of a "private equity bubble". We also do not fear an "economic meltdown" or a brutal end to the "Yen carry-trade" (which we did fear in the Spring of 2006). Instead, if we had to have one concern, it would have to be a possible change of monetary policy across Asia and the impact that this would have on real rates around the world. As we view things, the only reason Asian central banks would change their policies is if food prices continued to increase (in that respect, owning some soft commodities -- a hedge against rising real rates -- makes sense to us - as does owning Asian currencies). Interestingly, such a turn of events seems to be unfolding in India, yet no one seems to care. Monitoring changes in Asian inflation, monetary policies and exchange rates could prove more important than ever.
Nine months after that paper, we have indeed just gone through a period of a) rapidly rising food prices which have led to b) faster inflation rates across Asia, which have triggered c) a change in Asian monetary policy, notably a willingness to let the currencies appreciate faster than they have in the past. And if Asian central banks are now finally allowing their currencies to rise, then one thing is sure: Asian central banks will no longer need to print large amounts of their own currencies and accumulate US$ and Euros. They will thus also no longer need to buy US Treasuries and European bonds to the extent that they have.
Is it a co-incidence that, as Asia starts to allow its currencies to rise, US mortgages have been hitting the wall and spreads amongst European sovereigns have started to widen? The subsidy that Asian central banks have been giving to consumption in the US and governments in Europe (see The End is Not Nigh) is now disappearing.
Indeed, for the past five years, spreads of Italian ten-year government bonds to German bonds have hovered between 15bp and 25bp. But recently, spreads have started to break out on the upside.
And, of course, Italy is not alone. All across Europe, we have seen a widening of spreads between the "stronger" signatures (Germany, Holland, Austria, Finland, Ireland) and the "weaker" signatures (Portugal, Italy, Greece, Spain, Belgium, France) including those of Eastern Europe (Latvia, Romania, Hungary, Poland...).
Now as our more seasoned GaveKal reader will undeniably remember (see Divorce, Italian Style, or The End is Not Nigh), we have argued that spreads between Europe's sovereigns were set to widen for the past few years. And yet, nothing happened. Until, that is, we started to see Asian central banks allowing their currencies to start appreciating faster.
But what happens if Asian central banks now stop buying up European government debt to the tune of recent years? For a start, European money supply growth should decelerate rapidly and with it, economic activity. A bigger problem will then be the ability of European governments to raise further financing. Indeed, as economic activity tanks in Europe, and the Euro starts to fall, it is likely that investors will all of a sudden realize that governments only go bust when they issue debt in a currency that they cannot print.
In the past fifteen years, France government debt to GDP has moved from 35% in French Franc (i.e.: a currency the government could print at will) to 70% in Euros (i.e.: a currency that only the ECB can print). No wonder that Francois Fillon, the current French Prime Minister recently declared: "I run a state which now stands in a situation of financial bankruptcy, which has known deteriorating deficits for fifteen straight years and which has not voted a balanced budget for twenty-five years. This cannot last."
More importantly, the tightening-up of Europe's financial situation, and the widening of spreads between the "good borrowers" such as Austria, Finland or Germany and the "poorer borrowers" such as Italy, Greece, or Portugal, could have a devastating impact on Europe's commercial banks. Consider this piece of news from January 2008: "Landesbank Baden-Wuerttemberg, Germany's biggest state-owned bank, said 2007 profit will be about 300 million euros ($438.9 million) because of a drop in prices of banking and government securities. LBBW said it doesn't expect any defaults since the securities concerned have good ratings."
Less profits because of a drop in government securities? The careful reader may be somewhat surprised by this statement; after all, everywhere one cares to look across the OECD, government bond yields are close to their 2003 lows. So how did Germany's biggest state-owned bank manage to lose money on government securities? The answer, we believe finds its source in the funky regulations of Basel II. According to Basel II, an OECD country bank can sell a credit default swap on an OECD sovereign and this CDS:
- Does not have to be marked to market (since it is assumed that an OECD country will not default on its debt).
- Does not require the selling bank to put aside any capital on its balance sheet (since, once again, it is assumed that the country on which the CDS is written will not default).
In other words, for the past few years, clerks all over Europe's banks and insurance companies have boosted the bottom line with the "free money" that the sale of CDS provided. Every now and then, a clerk at the Treasury department of ABC Landesbanken would call up Goldman Sachs or Deutsche Bank and say: "I want to sell US$ 1bn of protection on Italy at 15bp for five years". And for five years, ABC Landesbanken would receive US$1.5 million without having to set aside capital on its balance sheet or take a "mark to market" risk on its income statement. Or so it thought...
Indeed, as the spreads between Italy and Germany start to widen something unexpected happens (a CDS will tend to reflect the spread between the issuer's debt and risk free debt of the same maturity. Otherwise an arbitrage could be made. If Italy's debt traded at 100bp over Germany and a CDS on Italy only cost 20bp, one could buy the Italian bond and buy the CDS and capture a "free" 80bp): ABC Landesbanken receives a margin call from Goldman Sachs and Deutsche Bank and, all of a sudden, what was a "risk and capital free" trade turns out to impact liquidity. Needless to say, this is the situation we are now in and this probably contributes further to the widening of spreads. All of a sudden, Europe's commercial banks are no longer keen to sell the spread as they have been for the past decade... in fact, they are most likely trying to buy back some of the contracts they wrote before they move too far against them.
In other words, a widening of spreads represents the worst of both worlds for European banks. For a start, it puts their balance sheets under pressure. For seconds, it cuts down their income as the writing of CDS on Europe's weaker sovereigns slows to a crawl.
For Europe's policy-makers, the widening of spreads poses a serious challenge which, if left unchecked, could cut to the very credibility of the Euro and the European construction exercise. It could also trigger a negative spiral such as the one we saw in the US whereby as the cost of borrowing increases on the weakest signatures, rolling over debt becomes more problematic, hereby inviting higher spreads etc... So how will Europe's politicians respond to this new challenge?
The widening of credit spreads across Europe reflects an economic reality. It makes no sense that say, Belgium and Ireland should borrow at the same rate.
The Euro 100bn question for investors should thus now be whether a) the recent widening is a one-off event and spreads are set to soon tighten again or b) the recent widening is the beginning of a more fundamentally-based re-pricing of risk across Euroland. The quandary now is whether politics can get us out!
In the mid 1990s, Europe's leaders got together and, in essence, said: "wouldn't it be great if we all got to borrow at the same rate as Germany?" And everyone around the table agreed that this would be a good thing. The decision was thus taken to a) create a currency which would resemble the DM, b) that this currency would be managed by a central bank with a mandate very similar to the Bundesbank's and c) that countries around the Euroland would strive to harmonize their fiscal policies (Maastricht Treaty rules and Stability and Growth Pact) to ensure the long term survival of the Euro. At the time it was also envisaged that the collapse in interest rates in certain countries (Italy, Belgium, Spain...) would give a tailwind to growth which would allow governments around the more indebted EMU countries to tighten their belts and clean up their fiscal houses.
The collapse in interest rates happened, as yields converged to the German rate... but unfortunately, the clean-up in fiscal houses did not. In fact some countries like France cashed in the "growth dividend" and voted themselves greater benefits such as the 35-hour work week.
Which brings us to today and the recent widening of spreads across Europe. This widening is a sign that the market is starting to acknowledge that the promises have not been kept. . But of course, the main problem with that solution is that it implies that Europe's governments will have to tighten their belts over the coming quarters, i.e.: at the worst possible time in the cycle. After all, it is always hard for a government to pull back and shrink its size of the GDP cake... but in an economic slowdown, it is close to impossible.
It is all the harder to do when there is little political will for far-reaching reforms. As a former German central banker once told us: "I use to think that France needed a Margaret Thatcher, I now realize she needs an Arthur Scargill" (Scargill was the Trotskyite leader of the Miner's Strike). In other words, to get a government to shrink its size, you first need a serious crisis (or a scarecrow a la Scargill); only then do people accept real sacrifices.
And we should make no mistake about it: reforming Europe's welfare states will take real sacrifices. Take pensions as an example: for years, most European countries have run a pay-as-you-go system whereby people of my generation will pay directly for the retirement benefits of my dad's generation (actually, this sounds like what I do at GaveKal every day). In other words, Europe's pension systems are usually massive pyramid schemes; they work as long as the base grows and ever more people contribute to the bottom of the pyramid. The problem, of course, is that in a growing number of European countries, the base is no longer growing.
As such, the off-balance sheet liabilities assumed by the government in matters of pensions which, until recently, had always been self-funding, are now set to come back on the governments' balance sheets. Now the last time Europe ran a comprehensive survey of pension liabilities was in 2003... and the data back then was scary. We guess the situation does not look any better today.
Europe's deteriorating demographic and pension situation alone means that Europe's governments do need to contemplate serious pension reform. Or, failing that, to open their borders to workers from all horizons in order to keep expanding the tax-paying, pension- contributing workforce. Needless to say, neither of these options is very enticing politically. As such, rather than convince millions of pensioners to cut their benefits, or work longer, Europe's politicians may be tempted to try and convince a small minority of central bankers sitting in Frankfurt to massively ease monetary policy and print a bunch of money to help the governments meet their liabilities.
In essence, the scenario we are painting is a simple one: the credit crunch which has thus far mostly only engulfed the US is starting to make its way into Europe. And soon enough, Europe's banks will likely be reporting losses and write-downs, and investors will flee to the safety of the highest government bond paper. Unfortunately for Italy, Greece, Belgium or Portugal, their paper does not qualify as "high quality".
Now as we highlighted earlier in this book, a credit crunch typically invites a "three-step" plan policy response. First, one collapses the currency (to make one's assets and goods more attractive to foreign capital and invite inward capital flows). Secondly, one needs to see the banks recapitalized (if the market can not do it, then the banks need to be nationalized). Thirdly, one puts in place a very steep yield curve in order to force the banks to start lending again and the private sector to take risk.
It is obvious today that this course of action is very much the preferred path of, for example, President Sarkozy. Hardly a day goes by without the French President taking the ECB to task for doing so little to help Europe's liquidity crunch. But each time he does, his comments are increasingly met by responses from Angela Merkel, the German Chancellor, for whom the independence of the ECB is sacrosanct.
The possibility of a massive easing from the ECB is nonetheless an interesting one and raises the question of how the market will respond to a more activist ECB. Would an ECB that did the bidding of politicians be seen as less of a Bundesbank and more of a Bank of Italy/Banque de France? And if so, would long bond yields across Europe be below 4% and the Euro at 1.55/US$? Would the foreign central banks that have been piling into European government paper remain keen to finance Europe's welfare states?
Another question, of course, is what would happen in the event of a bank bankruptcy in Europe? Would the ECB bail out the failing bank? Would the government of a failing bank be allowed to bend the EU's competition rules and nationalize the troubled financial institution? These are all questions with answers that remain unclear.
Of course, there is another way to go about dealing with a credit crunch: bitter infighting. This is what Japan did throughout the 1990s when the MoF would tell the BoJ that massive monetary easing was needed, only for the BoJ to turn around and say that the MoF needed to stop financing the construction of bridges that went from nowhere to nowhere. And as the infighting ensued, the Japanese banking system wrote off its entire capital base not once, but twice, over the course of the decade. Meanwhile investors shied away from all asset classes save the highest quality government bonds.
Could the same thing unfold in Europe? In Japan, there were only three sets of players (the BoJ, the MoF and the LDP) and over fifteen years, they could not seem to get the three-step plan (currency devaluation, bank recap, steep yield curve) right. In that regards, when considering the numbers of players involved in Europe, one may fear that the same policy paralysis could easily grip Europe. And, in this case, the recent break-out in the spreads that has now started will prove to have marked the start of a revolutionary trend for our financial markets: the end of the convergence trades and the start of the divergence trades.
A few years before his death, Professor Milton Friedman declared: "It seems to me that Europe, especially with the addition of more countries, is becoming ever-more susceptible to any asymmetric shock. Sooner or later, when the global economy hits a real bump, Europe's internal contradictions will tear it apart." Today, one should question whether the "real bump" is being hit and whether Milton Friedman will end up being proven right. But regardless of where one falls on the answers to these questions, one thing is sure: selling the bonds of Europe's weakest signatures and buying protection on Europe's weaker banks continues to make sense. It is some of the cheapest protection available against what remains a massive "fat- tail" risk to our financial systems. That's why we love this trade so much: the potential rewards are huge and the upfront costs still marginal. More importantly, it is a very good hedge against what would be a nightmare scenario for many financial institutions.
A Final Thought
In the next chapter of A Roadmap for Troubled Times, Louis goes into detail into how Italy might be the country to push the European Central Bank to take steps it might not otherwise want to take. Again, I strongly suggest you get the book. It is very thought-provoking and one of the better reads that I have had this year.