Rattlesnakes At The O.K. Corral

The weekend finally produced something of substance, although how much substance is clearly still open to question. It has been called an “all-in” bet by the EU, a metaphor meant to indicate that this is meant to be a pre-emptive move so strong that the opposition (in this case, markets) must back down. The metaphor is apt in more ways than one; in an all-in bet, there is nothing left to wagered if the bet is called. It is all or nothing.

“The Bank and the politicians listened to what the dealers were saying and took exactly the kind of rapid, decisive action that was needed to avert a crisis,” said [European Primary Dealers Association director Sander] Schol. “The proof that this it is the right course of action appears to be demonstrated by the market’s reaction.” – “Trichet Defends ECB Independence Amid Market Relief”, Wall Street Journal, 5/10/10

So, the fact that markets are going up proves that everything is all right. Surely nothing is better than a rising market, regardless of the reason it is rising. These are the people driving the train along such a scenic route, without having checked to see if the track goes all the way to the destination.

The EU package is a conceptual grab-bag: a pledge of up to €750bln in loans and loan guarantees, including about a third of that from the IMF; open-market purchases of sovereign and corporate bonds by the ECB and member central banks; the Federal Reserve’s reactivation of currency swap lines; and unlimited auctions of short-term money.

“The central banks are buying government bonds issued by Greece, Spain, Portugal, Ireland and Italy, a spokesman for the Association for Financial Markets in Europe, or AFME, told Dow Jones Newswires.”

Markets rallied, at least partly because (in the case of sovereign debt) the ECB was buying. Investors seemed shocked that leaders on the Continent came up with something meaningful, after months of trying to finesse the problem.

But did they really come up with something meaningful? One bond salesman reported, in a summary of overnight events, “…when asked at the press conference, EU Monetary Affairs Commissioner Rehn could not explain how the money will be used, when the facilities will be operational, or how the decision to allocate access to the funds will be made. It’s not yet clear, who will have this designating power (IMF/EU/EcoFin).”

Moreover, while the European elites believe that this is the way that decision-making in the EU is supposed to work, as the product of a powerful central committee that considers all the ramifications of any action on the fortunes of all member states, it is not yet the case that it really is the way it works in the balkanized politics of Europe. Just this weekend, Angela Merkel’s party lost control of the upper house of the German legislature. Who, then, has the power in Germany to sign off on this pledge? The heat doesn’t necessarily produce a nice, smooth, unified front from the rainbow of political interests. It is more like a box of Mike and Ikes left in the car: a sticky, gooey mess.

The news that the ECB is buying bonds – which is the only part of this that we definitively know is happening – is particularly interesting. The purchases will be “sterilized,” which is to say that the ECB isn’t directly monetizing the debt, as would be the case if for example the various governments issued debt and used the proceeds to help Greece, and then the ECB printed Euros to go buy the debt those governments had issued. The money being injected as a result of those bond purchases will be drained, probably by issuing ECB debt certificates. But this presents problems as well, since the short-term markets have been unhealthy of late (recall the chart of LIBOR from Friday’s comment). That detail aside, this means that the ECB is effectively levering up to replace the leverage that the crisis has been leeching away. Such leverage is normal for a central bank to some degree – when the Fed needs to add permanent reserves, it does so by buying Treasuries outright in a coupon or bill pass. But the difference is that Treasuries are highly unlikely to default. The Federal Reserve is limited in terms of the credit quality of the instruments it is allowed to buy, and in ordinary times they observe those rules (there was, um, some “slippage” from those rules during the crisis). What happens when Greece does default, as she almost surely will since these measures do nothing to soften the impact of the austerity measures? Then the ECB is holding worthless paper, and still is obliged on the debt certificates – and it must roll those debt certificates perpetually, or print the money to pay it off.

Inflation markets, recognizing perhaps that this is at least a small step towards monetization (especially if it fails), rallied smartly today. USD inflation swaps rose 7-10bps.

“The message has gotten through: the euro zone will defend its money,” French Finance Minister Christine Lagarde told reporters in Brussels early today..” (Bloomberg)

Oh really? The EU defends its money…by printing money? That is an interesting theory.

The S&P ended up with a 4.4% rally, which failed to fully reverse the Thursday-Friday plunge but wasn’t a bad showing. Volume was lighter on the bounce, at 1.8 trillion shares compared to 2.3 trillion and 2.4 trillion the last two days. To be sure, 1.8 trillion represents comfortably above-average volumes. While in general technicians like to see volume confirmation of market moves, in this case there is a reasonable excuse in that there was an overnight gap – prices adjusted, in short, without needing volume to push them up. That also means that there may be “trapped money” short, or at least not as long as they want to be, below the market. In turn, that could mean that the next declines will be slower as this money will provide natural buoyancy when prices revisit those levels.

And revisit them I think we will. It is appropriate that stocks didn’t reverse all of the prior plunge, because that drop wasn’t merely about Europe. It wasn’t just about the oil spill, or the volcanic eruption grounding air traffic for a week, or Fannie Mae needing another $8.4bln from the government…oh, wait, that last bit was today’s news. The reaction of the market last week was that of an overvalued market that suddenly had vertigo. It isn’t plain to me that, even if these actions “fix” the problem in Greece, that the vertigo is cured.

That said, we must always be cautious when institutions act to preserve themselves, as they can be brutal. When Lagarde told reporters that the euro zone will defend its money, what she meant was “we are cornered, and we will do whatever is necessary.” Remember that in the 2008 crisis, for the Fed that meant doing a number of things that were not strictly allowed by its enabling legislation. Institutions in crisis can sometimes cheat.

In the long run, markets will win. They will win because fair value is more patient than politicians. But even when he has been bitten by a rattlesnake, the man with two six-shooters can still win a gunfight before the poison does its work. Be on the side of the rattlesnake, but stay out of the crosshairs of the pistols!

The 10y note contract today dropped 24/32nds with 10y yields rising to 3.53%. There is no data tomorrow. Can you guess what the focus might be?