Fibs And Waves

A Quick Note on the IIF

2012-01-27T13:18:00.001-05:00

The IIF's (Institute of International Finance) MD, Charles Dallara, is heading negotations with the Greek government on PSI. The total PSI figure is about 200 billion euros. From Bloomberg,

"Financial firms on the IIF’s private-creditor investor committee, a larger group of 32 members that includes the smaller steering committee, hold more than 47 billion euros in Greek sovereign debt, according to data compiled by Bloomberg from company reports."

47/200 = 23.5% of private bondholders' holdings.

Question: Just how representative and binding will some type of eventual accord between the IIF and Greece really be?

Ψ Options (UPDATE 1)

2012-01-27T09:28:00.001-05:00

The title of this post is the Greek letter Psi, and, of course, I am going to talk briefly about the Private Sector Involvement in writing down Greece's debt. I already posted about this before, but things have changed quite a bit since then.

As a condition to getting its next bailout tranche to pay a March bond redemption, Greece needs to get private creditors to write down enough of the ~200 billion euros of Greek debt they hold to theoretically allow the country to achieve a debt to GDP ratio of 120% by 2020. Creditors are willing to voluntarily take about a 69% NPV haircut, for an average coupon of 4.25%. The troika wants a 3.5% coupon, which is more like an 80% NPV hit. If they don't come to an agreement, theoretically, Greece defaults - hard.

In my previous post, I spoke of potential blocking positions held by hedge funds. It seems this may not be as relevant as I thought. SoberLook has some great work about this issue, and I would refer you to this post and its comments.

So, if the hedgies are not in a position to block, what's the hold up? I think there are really two answers to the question. Worries about CDS' being triggered are not one of them.

Firstly, banks realize they hold the upper hand. A Greek default would cause the realization of losses for taxpayer funded entities, like the EFSF. So far, there have been no realized losses for governments, and every effort is being made to avoid them for fear of stirring public rage.

Secondly, the IMF has recently been applying pressure for public entities like the ECB to take part in the restructuring. They are doing this because their October 2011 estimates for 120% debt/GDP by 2020 with a 50% haircut have worsened along with Greece's economy, and that same haircut would now leave Greece with a 135% ratio. Of course, the ECB publicly is proclaiming that it will not take part in the restructuring, with Germany supporting their position. But, like nearly everything about this Euro crisis, be careful what you believe. As I see it, the ECB will take part in the haircut, as it is the single largest holder of GGB's, at an estimated 40 to 60 billion euros. (Whether that is par value or acquisition value, mostly at ~70 cents, I don't know.) To not do so would further frighten investors in distressed sovereigns, as the ECB as a super senior creditor would lessen the pool of discountable bonds should PSI be necessary elsewhere - like in Portugal, for example.

What are the ECB's options in this regard?

1. Retain the bonds and write down them down from par to the acquisition price. This would be seen, correctly, as debt monetization, and would probably not be enough of a write-down to make a difference.
2. Retain the bonds and write down them down to well below the acquisition price. Again, debt monetization, as well as a hit to the ECB's capital. It could make up the capital hit either through seniorage or a capital call to its shareholders.
3. Sell the bonds to the EFSF at the acquisition price, which will then do the write-down on its books. This would lead to the EFSF's first realized losses, and may serve as a wake-up call to its guarantors that this mess may actually cost their taxpayers some cash.
4. Sell the bonds back to Greece at the acquisition price. This would give Greece about 15 to 20 billion euros of debt forgiveness, assuming 45 to 60 billion par value GGB's acquired at a 30% discount. Of course, Greece does not have the money to buy back the bonds, so that would have to come from its bailout package, lowering the amount available for the future.

Of course, this all assumes that the technocratic government in Greece will be able to apply enough sphincter lube to accept the latest set of Troika demands, spelled out here: Troika spells out its demands

Stay tuned....

Greece, Portugal, And LTRO (TF Market Advisors)

UDPATE: "The German government wants Greece to cede sovereignty over tax and spending decisions to a eurozone “budget commissioner” to secure a second €130bn bail-out, according to a copy of the proposal obtained by the Financial Times." (FT) Now we're talking SERIOUS sphincter lube!

Stand Or Fall

2012-01-23T22:57:00.002-05:00

Remember this chart from my early October post? I used it to make the argument that the top in the DJI had not occurred in May of 2011 because the decline into June was not impulsive. Well, I still stand by it.

DJI SUMMER 2011

This is now important because the DJI has now exceeded its July high, which I mistakenly called the truncated top of Primary [B]. Obviously, this means that the DJI is NOT in Primary [C]!

So, where might it be? Three possibilities that come to mind, from most to least bearish.

1. Still in Intermediate (Z) of Primary [B].

DJI BLUE

2. In a Primary [X] wave of cycle b or w. Specifically, in Intermediate (B) of Primary [X], implying a (C) wave down to complete [X].

DJI ORANGE

3. Finished with Primary [X], and starting Primary [Y] of cycle b or w. This is a count that I believe Binve is showing, or something like it. To my eye, it gives us a very foreshortened Primary [X] wave.

DJI GREEN

I really don't know which of these three it might be. I'd like to go with the blue count, given that the other two counts look a bit ridiculous in the DAX, the MID, and others. However, the orange and green counts certainly look valid when you look at the SPX and DJI in isolation, and are bolstered perhaps by the contortions one has to go through to make the 2002 to 2007 rally into a five wave impulse.

To illustrate my point, the DAX weekly is shown, with notes on the chart.

DAX WEEKLY

If this count is correct, we should be very close to the top of Intermediate (2) of [C], as shown below. This chart gives two possible breakouts of (2). In black, we have a triple three w-x-y-x-z, which would be very close to a top. In magenta, we have a simpler a-b-c zig-zag, with Minor C of (2) evolving as a potential ending diagonal, as shown by the boundary lines. This could obviously take longer to resolve, and give us a bearish headfake signal quite soon as it progresses.

DAX 60 MIN

I'm interested in which DJI count you think is valid. Please record your vote by color with the reaction buttons below.

"An empty face reflects extinction
Ugly scars divide the nation
Desecrate the population
There will be no exaltation

Stand or fall
state your peace tonight
Stand or fall
Let's state it tonight

It's the euro theatre
It's the euro theatre
It's the euro theatre"

Final poll tally:

Blue: 8
Orange: 2
Green: 0

Thanks for voting.

RUT, DAX

2012-01-18T18:27:00.001-05:00

Well, here is a chance for me to look like a complete idiot. My current count has a completed ED in the RUT, with a bit more to go in the DAX.

RUT WEEKLY

RUT 60

RUT 10

DAX 60

I have re-removed the reactions buttons. If you want to call my counts non-sense, then you are going to have to grow a pair and put in a comment.

More DAX ED "Nonsense"

2012-01-17T14:24:00.000-05:00

Whoever checked the "nonsense" reaction button yesterday turns out to have been correct. Today's spirited rally in the DAX invalidated the ED the way I had it drawn. But, being possessed of a very hard head, here is another shot at it.

DAX 10 MIN

DAX 60 MIN

From a longer term perspective, many are looking at the action since March 09 as a cycle b or x wave. As the chart below shows, such a count really does not look plausible, IMHO, for the DAX.

DAX WEEKLY

DAX EOD

2012-01-16T13:20:00.002-05:00

I think we may be seeing (v) of [c] resolving as an ending diagonal, especially given the three wave look to i of (v).

DAX 10 MIN

The Credit Suisse Tome

2012-01-15T18:18:00.002-05:00

Credit Suisse has outdone itself! The workhorses in the European Fixed Income Research department have just released a 75 page novel entitled European Public Finances in 2012.

CS European Public Finances 2012

I highly recommend you give it a read! I am not going to attempt to regurgitate their entire paper here, but did want to make a few cogent comments.

The CS analysts adopt a relatively optimistic view. They base this on two factors.

- First of all, the evidence from the first of the ECB’s three-year LTROs is that much needed liquidity is being injected into the euro area financial system, which should ease, but not alleviate many of the sovereign and banking funding pressures; and

- Secondly, the slowdown in the euro area has, so far, been less acute than we – and other forecasters have anticipated. And the prospects for growth – driven by global developments – look, in the near term, to be slightly more promising than a few months ago.

They also believe that the ECB will massively ramp up its asset purchase program in a Fed/BoE style QE, and I will discuss this in a separate post.

With regard to their first point regarding liquidity, they argue that the first round of the LTRO added a net of 200 billion euros to the banking system. They anticipate that the late January halving of reserve requirements will add another 100 billion. Finally, they look for over 200 billion more in the February LTRO auction, at which time changes to collateral requirements will have taken effect.

CS goes on to point out that some of this liquidity is indeed finding its way into the sovereign debt markets, particularly in short duration instruments. An obvious case in point is the recent Spanish auction, at which Spain was able to sell twice its target amount in three year bonds. I will concede this point for now, although I think we need to be careful not to confuse bank funding pressures, which have been alleviated for now, with sovereign funding pressures. It is early to conclude that the LTRO has solved the sovereign issue, and the bond subordination issue I raised in my last post must be remembered, as well as the impending recapitalization challenges banks face (see SoberLook). The rotation into shorter term debt instruments is also a red flag. While one could fantasize about the European situation being solved in two or three years, rollover risks are building as debt maturities shorten. (Risks from ECB debt drip - MacroScope)

I won't discuss their second factor - you can read the paper if you're interested. I will say that page 11 begins an interesting discussion of austerity measures and their fiscal multipliers. One comment in particular strikes me as patently wrong:

"It is difficult to imagine that the deficitof a country would increaseas a consequence of a tax rise and/or expenditure cuts. Such an event would be quite extreme."

OK, then how about Greece???

Where I would particularly like to focus is on the discussion on pages 14 and 15, titled "Policy Hurdles." Here the team identifies three risk factors to their optimistic view.

PSI: I just did a post about this topic, and won't repeat it here.
Firewall Construction: Here the team discusses the EFSF, the ESM, and the IMF. With regard to the EFSF, their view remains optimistic, but their paper was published prior to the recent S&P downgrade. It is now quite likely that the EFSF will lose its own AAA rating, and S&P is reviewing the issue currently. This should finally put a fork in the wacky ideas regarding leveraging this facility. As to the ESM, the CS team would like to see its implementation moved up into mid 2012 (likely), its firepower increased above 500 bn (unlikely, given the attitude in Germany), its flexibility increased (unlikely, given Finnish and other objections to "qualified majority" decision making), and its senior creditor status abandoned (unlikely, as this superb SoberLook post argues.) Regarding the IMF, the CS team heralds the recent 150 billion euros put into a special fund by euro area countries as a resource yet to be recognized by the markets. This may be, but (1) it's chump change, and (2) the BRIC contribution they anticipate seems unlikely. If it comes about, it will most certainly go to the general fund, and not into the special fund for Europe. If the IMF General Fund contributes further to the EU crisis, IMF contributing countries will expect senior creditor status, further subordinating existing private bondholders.
Fiscal Compact: Here the CS team refers to the ambitious idea for tighter fiscal rules and balanced budget amendments to EZ country constitutions. They see implementation of this as critical to paving the way for ECB QE. Unfortunately, but not unexpectedly, this whole fiscal compact concept is dissolving into a weakly worded mush. (Eurozone deficit limits flexible under draft). That, in turn, has evoked the ire of the ECB, which wrote a strongly worded letter condemning the watering down of the original compact. (ECB raps revisions to draft fiscal pact) Whether, in the end, this topic would really be critical to the ECB's decision regarding QE is questionable, IMO.

I would conclude that all three of their risk factors look pretty risky about now.

The rest of the paper gives a country by country briefing, focusing on overview, financing needs (net and gross), public finances outlook, risks, and ratings. I honestly have not read every country's summary, but I certainly intend to, and recommend you do as well.

The Greek PSI

2012-01-15T15:37:00.000-05:00

As you know, talks broke down last week between the Greek government and creditors over the terms of a private sector restructuring of Greece's debt. Greece has approximately 250 billion euros of public debt outstanding, and about 206 billion of this is held in private hands. October's EU summit set a goal of reaching a near 100% "voluntary" participation rate in haircutting this privately held debt by 50%. If this could be achieved, we were told Greece would be on a sustainable path, with a debt/GDP ratio of a mere 120% by 2021**. Furthermore, further IMF/EU bailouts have been made conditional on this level of debt reduction. As Greece is dependent on an additional tranche of bailout money for a 14.4 billion euro bond redemption on March 20th, the PSI issue is becoming critical.

Greece's creditors include European banks, insurance companies, sovereign wealth funds, hedge funds, and distressed debt specialists. We can further divide these groups into:

-- those responsible for their own losses,
-- those who answer to the public for their losses, and
--those who, while technically responsible for their own losses, will get a bail-out.

I think looking at this way helps predict willingness to accept loss. Banks, and to some extent insurance companies, are in the third category. As a result, they are probably more vulnerable to official sector pressure to cooperate, and less concerned with the consequences of a loss. In fact, in the case of some of the banks, a realized loss on Greek debt might fit very nicely into their recapitalization scenarios as a tax provisioning scheme (think Citigroup).

Hedge funds are another story altogether. By some estimates, these funds may have control of around 80 billion of the 206 billion total in private hands. Obviously, these are holders who are solely responsible for their own gains/losses. Furthermore, many of these funds are relatively new investors in Greek debt, having bought it from delevering European banks over the past year or less. Given the obvious risks clearly visible in their investments, as well as their late entry into the market, many of these funds have paid quite handsomely for CDS (Credit Default Swap) protection on their positions. (For the most part, they did not get Greek CDS when they were trading at reasonable rates, although undoubtedly the cleverer ones most certainly did, and the bond purchases were just another facet of their longer term strategy.) These funds have disincentives to hold out for anything other than either par payment on their Greek bonds or a hard default that triggers payments on their CDS protection.

Sovereign wealth funds are an interesting category. Obviously, they answer to the public for their losses, and bailouts really don't apply here. They are interesting because they bring the biggest single hold-out in the Greek restructuring talks out of the shadows. That hold-out is, of course, the ECB, which is estimated to be the largest single holder of Greek sovereign debt at approximately 45 billion euros. The ECB has clearly held that it is not in the private sector, and will not be part of the current restructuring. Obviously, sovereign wealth funds make a similar argument - their bonds should be pari passu with the ECB.

So, what pressure can Greece bring on its creditors to cooperate? The answer comes in the form of retro-active collective action clauses (CAC), a measure which is currently under consideration in the Greek Parliament. The presence of these clauses could force the hand of any restructuring hold-outs - as long as they remain a minority. However, CAC's, and particularly retro-active CAC's, raise other issues.

CDS related: While the enactment of a retro-active CAC would not be a triggering event, almost certainly its enforcement would be.
ECB related: In a sovereign default, all bondholders are supposed to be pari passu. This is a principle that dates back to the first Paris Club restructuring in 1956. While the current effort to get private holders to voluntarily restructure could spare the ECB, a forced restructuring via a CAC would be legally much trickier unless all remaining bondholders were involved - to include the ECB. In this sense, the ECB is in a tough spot. If it partakes in restructuring it realizes losses against a highly leveraged 80 billion euro capital base and will likely have to make capital calls to its already strapped shareholders. If it insists on immunity from restructuring, it makes it crystal clear to holders of EU sovereign debt that, in the event of a future restructuring, haircuts will be larger based on the ECB's non-participation. Holders of Spanish and Italian debt will realize that they were effectively subordinated by the ECB's large SMP purchases in August, and may demand yields that reflect this increased exposure. Of course, the December EU summit declaration made some cleverly worded promises about PSI being unique to the Greek situation, while paradoxically putting CAC's into all future EU sovereign bond issuances. I was certainly not convinced, nor was Standard and Poors, as their downgrade statement makes clear:

"As we noted previously, we expect eurozone policymakers will accord ESM de-facto preferred creditor status in the event of a eurozone sovereign default. We believe that the prospect of subordination to a large creditor, which would have a key role in any future debt rescheduling, would make a lasting contribution to the rise in long-term government bond yields of lower-rated eurozone sovereigns and may reduce their future market access." (S&P)

Obviously, this issue of ECB purchases subordinating other holders would be a huge issue in the event of a large scale QE program by the ECB.

**Since those estimates were published, the Greek situation has deteriorated considerably. "J.P. Morgan warned in October that based on a 75 billion euros write-off and its expectations of a long recession, debt could reach 190% of GDP." (WSJ)

References:

Dealing with Greece’s biggest holdout (FTAV)

The Threats to Greece’s Debt Deal (WSJ)

No Finale for Greek Debt Drama (WSJ)

Awaiting a Greek Payout (NY Times)

Greece Will Wipe Away The Draghi Magic (WSJ)

UPDATE 5-Debt talks falter, Greeks warn of disaster (Reuters)

Hedge Funds Try to Profit From Greece Debt Swap (Bloomberg)

Euro Checkers: Guide to Greek PSI (WSJ)

Credit FAQ: Factors Behind Our Rating Actions On Eurozone Sovereign Governments (S&P)

Vega Threatens Lawsuit Over Greek Debt Talks (FINAlternatives)

Hedge Funds Complicate Greek Bailout (FINAlternatives)

Greece’s creditors seek end to deadlock (FT)

(Testosterone Pit)

I still plan on doing a post about possible ECB QE, but am finding the time to do so in short supply.

Fascinating Factoid:

Apple Computer; 30,000 people; Yearly Revenue $100 Bil
Greece: 11 million people, Yearly Revenue $300 Bil

An Approaching Top?

2012-01-11T01:28:00.001-05:00

The question is - of what? The RUT is showing some divergence on the hourly chart, and is in the process of testing its 200 DMA.

RUT 10 MIN

RUT 60 MIN

The DAX is the strongest of the big Eurozone indices at the moment, and the hourly chart points out some important differences between it and the French CAC, as well as the Spanish IBEX and Italian MIB.

DAX 10 MIN

DAX 60 MIN

Bigger picture, the blue and the magenta counts give you an idea of the debate going on in my brain. I think much depends on whether or not the ECB launches a QE operation or not. I intend to revisit that issue in my next macro post, but am waiting to see what happens with the ECB's interest (repo) rate on Thursday. A move toward QE would probably be heralded by a cut in the benchmark rate to 0.75%, perhaps even 0.5%. More on this later...

MID WEEKLY

TARGET2 Imbalances: Causes And Consequences

2012-01-07T16:53:00.001-05:00

TARGET2 is the European System of Central Bank's (ESCB) balance of payments mechanism. The acronym stands for Trans-European Automated Real-time Gross settlement Express Transfer system. The purpose of TARGET2 is to provide a mechanism for the real-time gross settlement of cross-border interbank and customer payments. The system allows for intra-day finality, which
insures that transactions will not be unwound if one of the parties fails to settle.
TARGET2 has recently been the subject of much attention given large imbalances that have appeared between net creditor NCBs (National Central Banks), such as the Bundesbank, and net debtor NCBs, such as the Bank of Ireland. Some have claimed that these imbalances are a "stealth-bailout" of the periphery by the core. Others claim that these imbalances are leading to restricted liquidity and possibly the need to sell NCB assets in the creditor nations. I shall humbly attempt to address these issues and explain how TARGET2 works. At the end, I will raise what I feel are concerns stemming from the existence of these imbalances.

How does TARGET2 work?

The system itself is rather complicated, and an understanding of it demands knowledge of what represents a bank asset versus a bank liability. For a non-bank commercial corporation, an asset is obviously something it owns, like plant, equipment, inventory, etc. The corporation's liabilities are things which it owes, like loans, payroll, pension obligations, etc. For a bank, the situation is reversed. A bank's liabilities are things it owes to others, such as demand deposits, while its assets are those things which are owed to it, such as loans.

With that background, let's look at an example of a funds transfer from a Spanish commercial bank (Bank "A") to a German commercial bank (Bank "B"). This transfer could either be a payment from one of the Bank A's account holders to a German corporation with an account at Bank B, or it could be the transfer of one of Bank A's demand deposit accounts to Bank B.

TARGET2 performs this transfer by debiting the Spanish bank's account at the Bank of Spain, and crediting the German bank's account at the Bundesbank. Note - the transfer occurs at the NCB level.

The Bundesbank now has a liability to the German commercial bank, in that the German bank can be thought of as holding a demand deposit at the Bundesbank.

On the other side of the transaction, the Bank of Spain debits the account of Spanish commercial bank (Bank A) for the amount of the funds transfer. This requires that the originating commercial bank have a sufficient credit balance in its central bank account. If it does not, then manner in which the bank pays for this debit will prove crucial in our discussion to follow.

THE CRUX OF THE MATTER

The Bundesbank's liability to Bank B is matched on the asset side of the balance sheet in the form of a claim on the Bank of Spain, just as the Bank of Spain's credit from Bank A is matched by a liability to the Bundesbank.

At the end of the transaction, the two NCB's positions are as shown below.

However, at the end of each business day, these NCB positions are assigned to the ECB. In this particular case, this leaves the Bundesbank with a claim on the ECB, and the ECB with a claim on the Bank of Spain.

It is important to remember that both legs of the transaction - the one that occurred in Spain, and the one that occurred in Germany - were settled independently of each other via the NCB's. It is only at the end of the day that positions are netted, and that takes place between the ECB and the NCBs. This is a characteristic of a gross settlement system versus a net settlement system, in which the failure of one party in the system can bring the entire settlement process to a halt.

So, that's how the system works. Now we will examine why the imbalances have arisen.

Why So Much Imbalance?

Imbalances in a gross payment system like TARGET2 are nothing unusual. In the past, NCBs usually displayed non-zero TARGET2 balances vis-à-vis the ECB, but the balance tended to be neutral on average. However, in the last few years some countries have seen their TARGET2 liabilities increase (and conversely others have seen their TARGET2 claims increase) up to six-fold or more. This chart from a MUST-READ note by Credit Suisse (CS) illustrates the problem as of Q3:2011.

To understand why this has occurred, let me take you back to that transaction I highlighted above (labeled as "The Crux of the Matter"), in which the Bank of Spain debits the account of the Spanish commercial bank - Bank A. In years past, that Spanish commercial bank, as well as most other banks in peripheral Europe, had ready access to private funding, often on an unsecured basis. That funding came from US Money Markets, direct investments, and interbank loans - often from commercial banks in the surplus countries of Europe, like Germany. Access to this private, largely unsecured funding is what allowed peripheral banks to pay off their liabilities to their respective NCBs.

However, starting in mid-2010 with the first stirrings of the Greek crisis, investors and depositors began to differentiate between the perceived risks of banks in the periphery versus the core, and this trend has done nothing but accelerate since. According to Fitch, US money market funds (MMF) reduced their exposure to European banks by over 45% in this year alone, and the remaining financing has migrated to much shorter duration instruments.

Additionally, the nature of the MMF funding has changed. MMFs have reduced their unsecured lending, partially replacing it with secured repo financing against collateral. (FT)

Furthermore, German banks have drastically cut their lending to the periphery, as is shown in the graph below, from the Bundesbank.

Finally, to add insult to injury, not only is private capital inflow to the periphery at a standstill, but we are also witnessing massive capital outflows in the form of depository flight from the periphery to the core, as illustrated in this CS graph.

In summary, we now have a situation in which the interbank market is dysfunctional, cross border loans have decreased and deposits are flowing out of the crisis countries. As a result, these net capital outflows settled through the national central banks result in the respective NCBs accumulating TARGET2 liabilities on their balance sheets, while the countries receiving the flows (e.g. Germany) accumulate TARGET2 claims. Peripheral banks can no longer fund themselves through the private markets, and it is the peripheral NCBs that now provide the funding in the form of secured loans against collateral.

To explain further, I find it hard to do better than quoting directly from the Credit Suisse paper.

"Due to the flight of liquidity from banks in the periphery, the ECB has stepped in and provided the liquidity, in the form of unlimited provision of funding to the banks against collateral – i.e., through MROs and LTROs.

For that reason NCBs’ balance sheets that show increased TARGET2 liabilities vis-à-vis the ECB, generally also display increased liquidity provisions through lending operations on the asset side. The ECB stepped in to play the role of liquidity provider when there was limited flow of private funds to crisis countries and increased TARGET2 liabilities largely reflect that.

The extent to which TARGET2 reflect these imbalances in liquidity needs across the euro area is demonstrated by Exhibit 5. It shows the refinancing operations (MROs and LTROs) on the balance sheet of the Bundesbank and the NCBs of the five peripheral economies. TARGET2 imbalances became increasingly noticeable not during the 2008-2009 crisis, when both Germany and the periphery required liquidity, but after 2010, when German liquidity needs sharply dropped away and the needs of the periphery continued to increase. This is shown clearly in Exhibit 6, which charts the difference between the value of the refinancing operations in the periphery and Germany against Bundesbank TARGET2 claims.

So the underlying factor driving the expansion of TARGET2 liabilities in the periphery is that capital outflows have intensified since the crisis, while the willingness of the private sector to finance these flows has decreased. This can be shown in Exhibits 7 and 8, which chart the behavior of the current account and TARGET2 imbalances in the periphery and Germany. Exhibit 7 shows that between 2007 and 2011 the periphery’s current account deficit has more or less been maintained, but the source financing this has switched from the private sector to ECB financing."

Hopefully, you now understand how these imbalances have arisen. I would also hope that it is clear that these imbalances are NOT the result of a deliberate stealth bailout of the periphery by the surplus NCBs. Instead the imbalances are a reflection of the funding difficulties in the periphery and are more driven by the actively derived negative balances of the peripheral NCBs than by the passively derived positive balance of the Bundesbank. (An important and related aspect of TARGET2 is that, while an NCB can place a credit limit on the TARGET2 balance of a commercial bank or other MFI, it cannot place such a limit on one of its fellow NCBs.)

Is There A Limit to TARGET2?

The short answer here is no. However, from a practical standpoint, the amount of eligible collateral that peripheral commercial banks can pledge to their NCBs is limiting. This is one of the main reasons the ECB recently relaxed collateral rules, expanded collateral eligibility, reduced reserve requirements, and expanded repo operations. Should losses be realized in the TARGET2 system as a consequence of a country default or exit, we could see positive balance NCBs (like the Bundesbank) demand a re-tightening of collateral eligibility rules, as well as the imposition of TARGET2 credit limits on some commercial financial institutions.

What are the Risks?

Let's start with the case of the Bundesbank, as they hold the largest TARGET2 credit position, by far. As of November 30, 2011, the balance was 495,164.155 Euros! The graph below charts its progress, and has undoubtedly shown explosive growth since the late December LTRO by the ECB.

It is critically important to remind ourselves that the Bundesbank's credit balance is held directly against the ECB, not against other NCBs. This is as a result of the end-of-day netting procedure in TARGET2. To date, no losses have been borne via TARGET2 imbalances. However, losses could potentially be realized in the case of default or exit from the Eurozone by a member country, but those losses would be borne and shared according to the ECB capital share of the remaining NCBs. In the case of the Bundesbank, that is currently 27%, but would obviously rise to some extent after the departure of the defaulting member. In the extreme case of a Eurozone collapse, losses to the Bundesbank obviously would be much more severe. Many claim that the desire to avoid realizing TARGET2 losses is one of the factors holding the Eurozone together, and preventing Greece from being allowed to default. When combined with issues regarding CDS, currency convertibility, social unrest, political turmoil, etc, I would agree.

Besides default risk, there is also a risk of the Bundesbank losing control over monetary policy in Germany. This is highlighted and explored in a paper entitled "TARGET2 Unlimited: Monetary Policy Implications of Asymmetric Liquidity Management with the Euro Area" from the University of Leipzig. Quoting from the abstract, the paper "analyses the implications of a continued divergence of TARGET2 balances for monetary policy in the euro area. The accumulation of TARGET2 claims (liabilities) would make ECB’s liquidity management asymmetric once the TARGET2 claims in core countries have crowded out central bank credit in those regions. Then while providing scarce liquidity to banks in countries with TARGET2 liabilities, the ECB will need to absorb excess liquidity in countries with TARGET2 claims. We discuss three alternatives and its implications to absorb excess liquidity in core regions: (1) Using market based measures might accelerate the capital flight from periphery to core countries and would add to the accumulation of risky assets by the ECB. (2) Conducting non-market based measures such as imposing differential (unremunerated) reserve requirements would distort banking markets and would support the development of shadow banking. (3) Staying passive would lead to decreasing interest rates in core Europe entailing inflationary pressure and overinvestment in those regions and possibly future instability of the banking system." It also addresses the faulty claim by Sinn and others that the Bundesbank would need to sell its gold reserves and other assets in order to continue to amass TARGET2 credits. I do not wish to delve into these very important issues here, but highly recommend those interested read the paper.

Moving beyond the isolated case of the Bundesbank, what are the risks TARGET2 imbalances imply for the Eurosystem in general? (I choose the phrase "imply for" versus "pose to" very deliberately. TARGET2 imbalances are more a symptom of the disease than its cause.)

One of the greatest risks, IMHO, is further asset encumbrance. I have posted about this previously. Remember, these TARGET2 imbalances represent the substitution of collateralized central bank funding of commercial banks for the unsecured funding that existed prior to Europe's sovereign debt crisis. As such, each central bank repo operation ties up evermore of the collateral available to commercial banks. We saw the ECB act to expand eligible collateral lately, but will it be enough? Are some banks now reaching encumbrance limits, as Dexia did?

Collateral quality is another risk, and we can already see some very transparent gamesmanship in this regard. Peter Tchir of TF Market Advisors speaks of Portugal guaranteeing a 3 year debt issuance by one of its commercial banks, who, in turn, gave the debt as collateral in an ECB repo operation. Zero Hedge relates that Greece, Italy, and others have been doing this for quite a while. Jens Weidmann, the Bundesbank President, told Bloomberg news on Dec 13 that he was more concerned with the quality of collateral than with the quantity. From the article, he is quoted as saying “In a situation like the current one, where we are providing solvent banks with liquidity, for me the size of the Target2 balances is less important than the risks we are taking on. It is my concern that we limit these risks as much as possible.”

Other Implications

Given the need to offer collateral in order to obtain NCB funding, it is not surprising that the ECB's 3 year LTRO offering in December saw such strong demand. The February offering will probably be similar. By that time we should have data to confirm that LTRO funding is being taken up disproportionately by peripheral banks. We should also be able to confirm the further widening of TARGET2 imbalances that would be the result of that disproportionality.

Regarding the sovereign debt and implications for the "Sarko" carry trade, we have seen relatively strong demand for short term Spanish and Italian debt leading up to the LTRO and since. However, longer term issuances, particularly in Italy, remain under pressure with little, if any, improvements in yield. Why might this be? My theory revolves around the collateral preferences of capital constrained peripheral banks. If you have 500 euros with which to buy sovereign debt that you intend to use as collateral with your NCB, would you rather:

buy five 100 € lower yielding short term issues that have a 5% haircut, giving you 475 € of collateral, or
buy ten 50 € higher yielding longer term issues that have a 10% haircut, giving you 450 € of collateral?

If my theory is correct, longer term sovereign debt in Italy and Spain should remain under pressure and we should gradually see a decline in duration, meaning more volatility, more debt rollovers, and greater difficulty in arriving at an exit strategy for the ECB. It may also mean that the ECB, through its Securities Markets Program (SMP), will hold a greater share of longer term Spanish and Italian debt than it currently does.

It must also be remembered that European banks face massive rollovers of their own debt in 2012. This makes it highly unlikely that a large portion of the proceed that they gain from ECB repos are going to be used to buy sovereign debt. Instead, schemes like the one I described above of having their respective governments guarantee bank debt for use as repo collateral may predominate. One could easily imagine the sovereign issuing those guarantees could demand some degree of quid pro quo with respect to sovereign debt purchases, but banks' own refunding requirements will be constraining. Furthermore, these bank debt guarantees should rightly show up as a new contingent liability for the sovereign issuing the guarantee, thereby worsening their sovereign debt situation further. Whether EUROSTAT will treat these guarantees as on balance sheet sovereign liabilities remains to be seen.

Finally, Wolf Richter has a recent post up regarding Germany's continued economic outperformance. To a great degree, this has been a direct result of the capital flows facilitated by the TARGET2 system.

Conclusion

TARGET2 imbalances are a reflection of ECB efforts to provide liquidity support to peripheral financial institutions that are no longer able to obtain their own private funding. They are not a stealth bailout, they do not constrain liquidity in countries with positive TARGET2 claims, and they are not an immediate threat to any NCB, to include the Bundesbank. However, they are a clear indication of the greater dependence on central bank financing in peripheral Europe. As the repo operations that give rise to these balances require quality collateral from capital constrained banks, they give rise to further asset encumbrance and continued competition for high quality collateral.

Are TARGET2 operations a game changer for Europe? I would say distinctly not, although they may keep the teams on the field for longer.

For Further Reading

**Missing the Target (Credit Suisse)**

The implications of intra-euro area imbalances in credit flows (CEPR)

Central Bank Imbalances in the Euro Area (FRBNY)

Goldman's Take On TARGET2 And How The Bundesbank Will Suffer Massive Losses If The Eurozone Fails (Zero Hedge)

Should We Worry About Target 2 Imbalances? (Nordea)

The fuss about TARGET2 (Reszatonline blog)

TARGET2 imbalances and the money supply disparity (Sober Look)

TARGET2 and the collateral imbalance - diagram (Sober Look)

TARGET2 Unlimited: Monetary Policy Implications of Asymmetric Liquidity Management with the Euro Area (Leipzig University)

The ECB’s stealth bailout (Sinn)

ECB and Hans-Werner Sinn on Target2 (??)

Eurozone Crisis, Act Two: Has the Bundesbank reached its limit? (Tornell, Westermann)

No, the Bundesbank has not reached its limit (Karl Whelan)

Germany’s Hidden Risk: Bloomberg Businessweek Opening Remarks

DAX, RUT Update

2012-01-05T13:26:00.001-05:00

My take on today's decline in the RUT was that it marked the end of an expanding ED for a c wave of (iv) of [c]. A break below today's lows would obviously change that view.

RUT 10 MIN

The DAX still appears to be consolidating, as opposed to declining. I am unable to see anything impulsive/motive looking about the decline off the magenta top, although my confidence in my ability to recognize a first wave declines by the minute. I think the French and EFSF bond auction results today have given some near term relief. We'll see what Italy and Spain bring next week.

DAX 10 MIN

Do any of you have any interest in my doing a post about TARGET2 imbalances and their meaning? There is already a lot of stuff out there on the subject, so I hesitate to waste my time unless there is some genuine interest.

Big DAX Day

2012-01-02T19:40:00.000-05:00

The DAX was up a full 3% today on light volume. Unfortunately, it still does not resolve the dilemma between the two counts I presented on 29 Dec. The DAX is currently very close to an important lateral resistance level, so what happens here should help us figure out whether we double top near 64xx or truncate badly near present levels.

DAX WEEKLY

DAX DAILY

At a significant .618 fib of the entire [B] wave, and a hypothetical channel line.

DAX 60 MIN

DAX 10 MIN

Divergent RSI - so far...

Still A Toss-Up

2011-12-29T22:58:00.002-05:00

Just some small changes to the two count alternatives I gave last week, with little new to say.

RUT 60

RUT 10 PURPLE

RUT 10 GREEN

I still think the DAX will end up as the driver here, and, unfortunately, I am still torn between the two counts shown in the 10 minute chart.

DAX 60

DAX 10

Asset Encumbrance and Stress in the European Interbank Markets

2011-12-24T14:28:00.001-05:00

Asset Encumbrance is the new watchword I want my readers to be familiar with. It is the reason the ECB did its recent 3 year LTRO. It is the mechanism by which Dexia failed. It is the reason that the uptake on the LTRO was so surprisingly huge.

So, what it is asset encumbrance? In its simplest definition, encumbrance is a claim against an asset by another party. In relation to banks, encumbered assets are assets of the bank which have been pledged as collateral to back a secured loan or covered bond.

The degree of asset encumbrance is a real issue for European banks, as almost all interbank lending and bank financing is now being done via secured lending or the issuance of covered bonds. The unsecured senior debt market has been pretty much frozen for all but a few European banks since the summer. Looking at Dexia, the following excerpt from an October 29th FT article tells the story:

"Just three months ago, Dexia announced it had €88bn ($121bn) of quality assets on its balance sheet. With the European Central Bank offering funding for the region’s troubled financials against such collateral, this sum should have been enough to stave off disaster at the Franco-Belgian bank.
Except for one problem: less than a quarter of that €88bn was actually free to be used as ECB collateral.

Some €68bn of the assets had been already tied up, or “encumbered”, in the bank’s various funding programmes, including tapping the ECB for extra money – a factor that helped precipitate Dexia’s move into government arms this month.

With more and more banks resorting to so-called “secured funding” – or financing that is backed by specific pools of a bank’s own collateral – concerns are rising over the growing levels of such asset encumbrance."

As unsecured lending has disappeared in Europe, banks have been scrambling to obtain the highest quality collateral, which partially explains the penalizingly low yields on German and Dutch short term paper. Of note, these yields have declined even further since Wednesday's LTRO auction, just as Spanish and Italian yields rose, with the Italian 10 year bond popping back up over the ominous 7% level. (Spanish Bonds Fall After ECB; German Note Yields Drop to Record Bloomberg) Essentially, traders are willing to take a loss in order to obtain the safest securities as collateral. This does not bode particularly well for the "Sarkozy" carry trade.

GERMAN 2 YR

DUTCH 2 YR

ITALIAN 10YR

Note: the pre-LTRO improvement is almost completely erased.

SPANISH 10 YR

Note: The LTRO effect is holding, but watch that recent reversal.

The much heralded LTRO resulted in a net new issuance of about 210 billion euros of liquidity from the ECB. However, and this is an important however, that liquidity is in the form of collateralized loans that are marked to market. Hence, from a different perspective, the 3 year LTRO newly encumbered approximately 210 billion euros of bank assets for a much longer term. Furthermore, assets rolled from shorter term facilities into the new three year facility are also obviously tied up for a considerably longer period. The risk here is "that unlimited ECB liquidity provision, by taking collateral out of the market, is undermining private secured lending which typically recycles collateral. It is a particularly perverse liquidity trap in which central bank loosening can precipitate a credit crunch." (FT) This phenomenon has already led to broad downgrades for the credit ratings of most European banks' senior unsecured debt. BTW, this is the same thing that is occurring in the sovereign bond market. As super senior secured creditors, such as the ECB and IMF, take larger positions in a sovereign's bond market, private sector bondholders are pushed further down the ladder in case of default, notwithstanding any EU ~~bullshit~~ ambiguously worded promises about PSI (private sector involvement).

A key indicator of the degree of the stress in the European interbank secured lending market is a measure known as the EUREPO. (A HUGE hat tip to SoberLook for an excellent post on this subject, which can be found here.) This is a measure of the haircut applied to collateral offered to secure a repurchase agreement. The higher the EUREPO, the greater value given to the collateral. The lower the EUREPO, the less the value given to the collateral. In a low EUREPO environment, a much larger amount of collateral has to be pledged (or encumbered) in order to obtain an equivalent amount of funding. Obviously, the perceived risk of the collateral itself also plays a big role, and banks would have to offer considerably more Spanish or Italian debt than German debt if they were seeking repo funding. Again, this does not bode well for the Sarkozy carry trade. The graph below tells the story.

3 MONTH EUREPO

A picture is worth a thousand words....

A story not told by the EUREPO rate chart is the structure of repurchase agreements in Europe. Most European repo deals are now what is called Triparty Repo. In Triparty repo, a neutral third party is contracted to be the holder of the pledged collateral. This prevents what is known as rehypothecation, which is a method of recycling collateral to obtain more loans. In rehypothecation, a bank takes collateral pledged to it and recycles it to another institution in order to obtain funding. Lehman used a variety of rehypothecation to cook its books prior to its collapse, with the result that creditors who thought themselves to be secured ended up in line with unsecured creditors, as collateral levels and ownership became very difficult to track. With triparty repo, this is not supposed to happen.

Another indicator to watch is the spread between EURIBOR and EUREPO. EURIBOR measures the interest rate banks charge one another for unsecured lending. As SoberLook and I point out, there is hardly any unsecured lending occurring in the European Interbank market, so the quote here is somewhat misleading. Nevertheless, the spread between the three month unsecured EURIBOR lending rate and the secured EUREPO of similar maturity is now at 127 points. These are levels not seen since December of 2008. I do not have the peak level for three month rates, but the peak spread for 12 months was at 230 on October 31, 2008. The 12 month spread is currently at 175.6, which is the highest it has been since 2008 as well.

3 MONTH EURIBOR

The recent sharp drop is a result of the 0.5% benchmark rate reduction from the ECB

Yet another indicator to watch is the Markit ITraxx European Senior Financial index. One year ago, it quoted a spread of ~150 points for a 5 year contract. The latest quote is 275, close to double!

ITRAXX EUROPE FINANCIALS

Finally, the last stress indicator to watch is the use of the ECB's Overnight Deposit Facility. Banks place funds here when they basically can find no better, or safer, use for the money. The use of this facility has been making new record highs on a regular basis now, and just made a new record on Thursday - after the LTRO. From the WSJ:

The high level reflects ongoing distrust in inter-bank lending markets, where banks prefer using the ECB facility as a safe haven for excess funds rather than lending them to other banks.
The high deposit level also suggests markets aren't fully convinced that the ECB's massive long-term loan allotment is enough to fortify the currency bloc's banking sector.

ECB OVERNIGHT DEPOSIT FACILITY USAGE

What could the ECB do about all of these interbank stresses? It has already take some steps, to include reduction of reserve requirements from 2% to 1%, freeing up about 100 billion euros as possible collateral. It also dramatically broadened the assets it will accept as collateral to now include unsecuritized loan portfolios and lower rated sovereign assets. It did stop short of accepting dry cleaning receipts, for now anyway. And, of course, the biggie was the repo facility itself. However, as I have tried to show, the more banks repo with the ECB, the greater the degree of asset encumbrance they generate. As assets become more generally encumbered, accounting can give the illusion of greater financial strength and liquidity than may actually be the case, as we learned from Dexia. Of course, banks know this, which has led to a high degree of mistrust in the interbank markets and a much greater degree of dependency on the ECB. Creditors also know this, which has led to a freezing of unsecured lending to banks. The second round of LTRO, scheduled for February, is likely to exacerbate this situation further.

Other measures that could be undertaken would be lowering haircut rates for collateral, thus allowing less collateral to obtain funding from the ECB. Such a measure would certainly make Bagehot roll over in his grave, but I have to think he must be on about his tenth roll by now anyway. Allowing the use of non-Euro denominated securities, such as US Treasuries, to be used as collateral at the ECB could also be done, but this could backfire and increase selling pressure on weak European sovereigns.

So, why should you care about all of this stress in the European Interbank market?

Firstly, it is highly indicative of an ongoing and escalating credit crunch in Europe. This is already having contractionary effects on the private sector, as detailed in this article from Reuters:

"The stresses from banks are already spilling into the wider economy, as banks take a harder line on their lending.

French media and telecoms group Vivendi has been forced to raise the pricing on a 1.5 billion euro loan refinancing and Danish brewer Carlsberg is also meeting resistance from banks for a new loan.

A stark retreat in areas like project finance, shipping finance, aviation and infrastructure, as banks get rid of assets funded by U.S. dollars, may be less politically sensitive than cutting lending to small businesses, but it will slow economic growth.

The shipping industry, for example, is facing a major storm from the banks' retreat, with shippers cancelling or delaying orders as owners get strapped for cash.

The situation may get worse: analysts at Morgan Stanley estimate Europe's banks could shed up to 3 trillion euros in the next 2-3 years and up to 4.5 trillion euros in the next 5-6 years as the full extent of the financial crisis becomes clear."

Secondly, it is creating a much greater degree of symbiosis between the central bank and private banks, raising serious questions about eventual exit strategies. Gillian Tett has an interesting perspective on this in the FT, and I highly recommend it. The issues she raises are worth are post in of themselves.

Thirdly, it has strong implications for the Sarkozy carry trade. This is the idea that banks will use large portions of their LTRO borrowing to prop up sovereign debt. Let me set the stage...

European banks have 725 billion euros of maturing debt in 2012, with 282 billion due in the first quarter alone. US money market funding of European banks is in full retreat, with exposure to French banks cut by 68% in November alone. US money market funding to Europe in general has decreased by 45% since May, according to Fitch. The unsecured lending market in Europe is frozen. The secured repo environment - one of the few fund sources available outside of the ECB - is demanding overcollateralized deals with only the highest quality collateral, as evidenced by EUREPO rates. This secured lending is also resulting in a worrying degree of asset encumbrance. The ECB is applying haircuts on its lending, and marking collateral to market. In this environment, obtaining a given quantity of repo funding using Italian bonds as collateral would require a bank to pledge/encumber a much larger amount of its assets than it would if it pledged German bunds. It would also expose the bank to more MTM risk down the line.

This train of thought can lead us to a potential conclusion regarding the recent strong improvement in short term Spanish paper. This could very well have been due to banks scooping up cheap collateral that only the ECB would accept, and may not continue. We may very well see another spate of this in the run up to the February auction, although this could be muted if banks either suffer MTM collateral calls or run up against asset encumbrance regulatory limits in the interim.

Fourthly, and finally, increasing asset encumbrance through securitized borrowing could lead to bank failures ala Dexia and Bear Stearns should bank counterparties demand more collateral from banks than they are able to produce.

I'll leave you with a reading recommendation for a brilliant article by John Glover on Bloomberg entitled "Bonds Stop Flowing as Collateral Gets Stuck at ECB: Euro Credit." This article was the inspiration for this post, and I strongly recommend you read it.

Merry Christmas to all!

28 Dec Update WSJ is catching on to this story: Europe's Banks Face Pressure on Collateral

Through the Roof of Your Mouth...

2011-12-23T20:30:00.002-05:00

Through the mouth of your eye...

The two options I am grappling with for the RUT are shown below.

The Green option has more bullish potential, and [c] = [a] at 794.38.

RUT 10 GREEN

The purple count is somewhat sneakier, and foresees a probably slightly truncated double top, just enough to close the Papandreau referendum gap from late October, near 759.

RUT 10 PURPLE

I think much depends on what happens next in Europe. The DAX has been really lagging the US indices in this most recent rally phase. (See this post from SoberLook) The big question is whether this lag has just been a slow start that is about to explode upwards to catch up, or a very weak rally that will lead to a severely truncated finish to Z of (2). The black count depicts the former, and the magenta the latter. Obviously, black DAX corresponds to the green RUT count above, and black DAX up to a double top near 6440 could very well mean the RUT goes to the 794+ level. Magenta DAX looks for an ugly truncation near the considerable lateral resistance level closer to 6130 (see 60 min chart).

DAX 10

DAX 60 MIN

I want to do a post on the collateral crunch in Europe and the recent LTRO implications, but I am not sure I'll get it done for a bit with the holidays upon us. So, I'll take this opportunity to wish you all a very Merry Christmas, or whatever holiday you happen to celebrate.

Seid umschlungen, Millionen!

Diesen Kuß der ganzen Welt!

The LTRO Rally

2011-12-21T00:30:00.000-05:00

I have to laugh when I hear some radio announcer on Bloomberg or CNBC opining about why the market went up on a given day. Today the line was something like "as stronger than expected housing starts gave 'investors' confidence that the world's largest economy will withstand the European debt crisis." GAG!

IMHO, the market rallied today off of another in a series of very well-subscribed short term Spanish auctions.

"Yields in the Spanish auction of three-month debt fell to 1.74 per cent, down from 5.11 per cent in a similar auction in November. Spain’s six-month yields dropped to 2.44 per cent from 5.23 per cent last month. Madrid also raised €5.64bn, more than allotted, in another sign of strong demand.
Market participants said the auctions were helped by Spanish banks wanting to use the paper as collateral at the European Central Bank’s loan tenders on Wednesday. The central bank is offering its first of two three-year loans, as part of its emergency liquidity programme." (FT)

As I noted before, I think this probably represents some banks loading up on government securities to use at tomorrow's ECB LTRO auction. Demand at the auction is estimated to range at between 300 and 550 billion euros. European banks have 720 billion euros of debt to roll-over in 2012, and, with capital markets frozen for many of them, the official purpose of the facility is to offer banks sufficient liquidity to allow them to resume lending and avoid asset fire sales.

However, what has the market so rabidly excited is the Sarkozy trade, in which these banks would use ECB liquidity to purchase large amounts of sovereign debt, pocketing the interest rate differential as a carry trade. In June 2009, about half of the 442 billion euros in the one year LTRO went into exactly such a trade.

How likely is this to happen again? Will it be substantial enough to make a difference given the funding needs of European governments in 2012? What could be the side effects?

According to many, this kind of fund flow into sovereign debt is less likely in this round. Reasons for this include:

Leverage issues, especially in the light of EBA ~~sham~~ "stress" tests.
Bank funding issues, as mentioned above.
Cost of hedging via CDS market is much higher now versus 2009.
Confidence in effectiveness of CDS hedges is much lower now, given the efforts to avoid a triggering event in the Greek debacle.
Exposure to collateral calls. Throughout the term of this three year facility, the ECB will mark-to-market bonds held as collateral. If bond values falter, banks could have to pony up additional collateral to the ECB. This may exacerbate their own funding issues.
Interest rate risk. Loan rates are subject to change if the ECB's benchmark fund rates increases during the three year term. Unlike the FED, the ECB has not pledged to keep rates at the current 1% for a specific period.
Shareholder Perceptions (aka Stigma): This time around, there is a prevailing sense of over-exposure to sovereign debt, and a greatly diminished perception of its safety. Banks may not want to be seen as piling into more of it. There may also be a hesitancy, especially among larger banks, to not be seen as being too dependent on Central bank funding.
Bondholder Perceptions: To quote from an RBC note, "the more a bank uses up ECB liquidity and other forms of collateralized funding, the more the senior unsecured becomes subordinated in the liabilities structure."
Duration Risk*: Apparently, (this is not certain) ECB rules require that the collateral offered not expire during the term of the loan. I believe that banks will have the option to unwind the trade one year into it, so this could mitigate these risks to some degree by allowing the pledging of shorter term bonds. As an aside, this brings up the question of a possible large spread developing between the long and short end of the European sovereign debt market, with governments only able to affordably fund themselves short term. An effective transition to shorter term funding is NOT what Europe needs at this time, and would raise the obvious question as to how the ECB would ever be able to unwind this LTRO facility.

As to the effective size of a potential Sarkozy trade, this is really the big question, and I honestly haven't a clue. From a FTAV post, a Morgan Stanley analyst offers the following estimate:

How impactful? Today government bonds+loans are 7% of Spanish banks assets and 9% in Italy vs 18% in Greece. Should domestic Spanish banks increase the ratio by 1-3% in 2012, this could create €15-45bn of buying presumably at the front end of the curve. This said, there are many numerous obstacles to cross.

In a different FTAV post, SocGen gives the following assessment:

Euro area banks have some 6% of total assets in government bonds (with ratios slightly higher at 7% to 9% in Spain and Italy as per the most recent EBA data). If half of all Spanish and Italian banks (it is unlikely to be the larger names) were to raise the ratio by 1% next year, that would lead them to buy some €8bn-€10bn in each country. Most likely the impact would be far less, and graduated over time. Buying though on such a scale is modest as a percentage of total issuance (some 9% in Spain, 4% in Italy).

From the tone of these two notes, it certainly does not look like this would make much of a dent in the funding needs of European governments next year. To put this in further context, the reader is reminded that the ECB has already purchased 136 billion euros of Italian and Spanish debt through its Securities Markets Program. Prior to this very recent "LTRO mania," this degree of ECB intervention had done precious little to reign in yields. Furthermore, looking out over the three year term of this LTRO, the combined funding costs for Italy and Spain alone amount to 1.7 TRILLION euros! (Source: Open Europe Briefing Note 19 Dec 2011 "The Battle for the Heart and Soul of the ECB" READ IT!)

As to side effects, we've been over those. I would like to add the currency risk to foreign holders of euro area debt as another factor which could lead foreign holders (outside of EMU) of EMU debt to sell. This would further increase both the intra-country and the intra-EMU concentration risks I have alluded to before, and which Rik has expounded upon in the comments sections.

Bottom line, we shall see how this develops. My count remains as in my Quick Count post.

*Regarding duration risk, you can check out a conversation I am having regarding whether or not collateral placed with the ECB is fungible (substitutable) during the term of the LTRO in this post at SoberLook.com

The Battle for the ECB

2011-12-19T20:00:00.000-05:00

Very brief post to recommend two readings:

The battle for the heart and soul of the ECB (Open Europe Blog)

The carry trade and the goldilocks LTRO (FTAV)

Quick Count

2011-12-19T16:37:00.002-05:00

SPX 10

Perseverating About the LTRO

2011-12-17T17:26:00.000-05:00

Randy Waldman at Interfluidity has a post up titled "The Eurozone’s policy breakthrough?" Now, Randy is one hell of a smart guy, and I pay close attention when he posts something - at least when I can understand it, as some of it goes way over my head. So, given how important I feel this issue is, I want to look critically at his argument.

Waldman first notes the degree of confidence reported to be privately present in the German policy establishment. I say that's fine, confidence is good, but is it well placed or is it a manifestation of denial?

He then goes on to bring up the arguments put forward by Tyler Cowen of Marginal Revolution. These are arguments largely based on the potential attractiveness of the carry trade the ECB is offering, as well as on the recent very favorable bond market reaction in shorter term French, Italian and Spanish paper.

ITALIAN 2 YR

SPANISH 2 YR

FRENCH 2 YR

Looking at these yields, this is certainly an early indication that, despite denials, somebody is doing some buying.

Waldman then moves on to make the desperation argument for bank participation, stating that peripheral European banks are "mortally dependent" on ECB liquidity. If the ECB says jump, these banks are simply going to ask "how high?" Rather than just being about a carry trade profit, Randy argues that the ECB has these banks so far over the barrel as to be able to force them into these trades. For Randy, potential bank insolvency is more of a motivator for these banks to double down and participate than not. Can't say as I disagree. However, as Rik pointed out in comments, participation in this program could come to be seen as a public marker of extreme desperation, leading to potential speculative attack.

He further argues that the ECB will be able to rather surgically command what these banks will buy and sell based on collateral haircuts offered at the LTRO. This last point raises the obvious question of instability raised by collateral haircut manipulation. If the amount of collateral required for a given sovereign's bonds is in constant flux based on ECB targeting, does this inspire confidence?

Randy concludes with some criticisms of the power en obscura such a program could give to the ECB - an argument that I completely agree with and have made before.

So, in summary, I will concede the following points:

Short term sovereign funding markets certainly do seem to be signalling adoption of the ECB carry trade.
Desperate banks may be willing to do desperate things.
The ECB may be able to "direct" funds towards the bond issues it wishes to target.

I will begin my rebuttal with the following quote from Randy: "It’s the same as direct ECB lending to sovereigns, except ECB gets added security (in theory) by interposing banks as guarantors, and pays a fee for the privilege." To me, this is rather like sending your children into your burning house to put out the fire. As I indicated in an earlier post, this is indeed ass-backwards QE. Unlike real QE, in which the risky assets end up on the central bank's infinite balance sheet and the banks' balance sheets are cleared, this only serves to further encumber bank balance sheets and increase leverage. It is a doubling down - a desparate Martingale type approach to supporting sovereign bonds. From my earlier post:

"With the FED, the PD's buy the bonds, and then the FED buys them in the secondary market from the PD's. In the end, it is the FED, with its "infinite" balance sheet that becomes leveraged. In the SARKO variety, the ECB extends non-loss bearing loans to banks which then have to lever up their own balance sheets even more to buy these instruments. In the FED case, bank get capital injections and the CB gets HTM paper. In the ECB case, banks take on senior loans, offering very volatile sovereign paper as collateral."

Furthermore, this approach to QE increases concentration risk enormously. By providing incentives to Eurozone banks to conduct this carry trade, they become the willing buyers of EMU sovereign debt holdings put on offer by foreign banks, and crowd foreign banks out of the bid on new issues.

Another concern has to do with domestic lending within the EMU. If bank balance sheets become even further encumbered with sovereign debt, how much funding does this leave remaining for non-governmental lending? After all, how does growth return with governments hell-bent on austerity and credit being allocated towards a carry trade instead of business expansion?

Bank refinancing is also a concern, as is leverage. European banks face considerable debt rollovers next year, and the bond market remains largely closed to them. From the IFR, "Indeed, the European banking industry collectively needs to pay back or refinance about €650bn of liabilities next year – Lloyds, UniCredit, BNP Paribas, RBS and HSBC face the most, each having €30bn or more of instruments maturing, according to estimates from Nomura. With bank debts coming due and most firms unable to raise fresh funds in bond markets – which remain largely closed – bankers say it is much more prudent to use ECB loans to pay off their own creditors rather than speculate that European governments pay back all their debt. 'Banks need this liquidity to get them through the wall of refinancing they are facing next year,' said the capital markets head. 'That’s where the money is going to go. Banks need to deleverage rather than re-leverage. It’s just wishful thinking that they will pile back into government bonds.'" Will re-leveraging bank balance sheets with even more sovereign debt make the bank-funding markets more, or less, accomodative?

Bank credit ratings are another concern. I find it implausible that a concentrated doubling down on riskier sovereign assets would go unnoticed by the rating agencies.

Sovereign ratings are also a concern. These ratings are not simply based on prevailing interest rates, but also on growth prospects and long term debt sustainability. With Europe in a recession and growth slowing, funding a sovereign debt carry trade may cause growth to slow further. Furthermore, other than possibly by buying time, this maneuver does nothing to address long term debt sustainability in Europe.

Potentially, one could even envision success in this effort causing German yields to come into the spotlight. Until now, German bunds have been in scarcity, as they have been in extreme demand as collateral for repo operations. If this is no longer the case, and France looses its wholly undeserved AAA, do the implied demands on Germany come center stage? Obviously, German yields have a long ways to go to become worrisome, but the failed bund auction of November should make us wary.

I won't even begin to delve into the topic of North-South wage and productivity mismatches, and how this ECB program does absolutely nothing to address these longer term issues. In fact, if anything, success here would simply lead to reversion to the status quo. I won't touch the concept that a broken model of socialism, which works just fine until you run out of other people's money (OPM), has, indeed, run out of OPM.

So, has my opinion changed? Is the ECB's LTRO is a "comprehensive solution" to the Eurozone debt crisis? I will answer that with a question - did the Kamikazes win Japan the war?

For some other perspectives, not necessarily supportive of my point of view, I suggest:

THE HOTTEST QUESTION IN EUROPE: Did The ECB Just Pull Off A Back-Door Bailout That Will End The Crisis? (Business Insider)

It is finally being recognized that the eurozone made a major policy breakthrough (Marginal Revolution)

What is the difference between LOLR to banks and LOLR to governments? (Marginal Revolution)

ECB Backdoor Bailout (Modelled Behavior)

The Corzine Trade Vs French Downgrade (ZH)

Why ECB lending won’t solve the euro crisis (Felix Salmon)

EU/IMF halt Hungary talks after c.bank row (Reuters) This is pretty much unrelated, but looks important enough to track as a bogey.

Doubling Down

2011-12-15T14:58:00.000-05:00

“There is no external savior for a country that doesn’t want to save itself,” Draghi said in a speech in Berlin today.“I will never tire of saying the first response should come from the countries.” Draghi Says There’s No External Savior for Euro Countries That Fail to Act

I insist that the markets still do not believe this. If they did, they'd be 30+% lower than they are today. Articles like this one, Bank of America sees deeper eurozone crisis before ECB rescue, prove my point.

However, that is not the point of my post. I want to go back to the idea of Bass-Ackwards QE from my last post, as I think this topic is going to be what moves markets in the near term. What brings me back to this theme is the result of an over-subscribed Spanish bond auction yesterday morning. "The Spanish Treasury sold €6.028 billion bonds against its target range of €2.5 billion to €3.5 billion of the 3.15% January 2016, 4% April 2020 and 5.50% April 2021 bonds. It received total bids of €11.214 billion, implying a comfortable coverage of the amount sold and allowing the issuer to raise more cash than planned. ... Spain paid an average yield of 4.023% on the January 2016 bond versus 5.276% at its previous auction Dec. 1. The average yield on the April 2020 bond was 5.201% versus 5.006%at the previous sale Sept. 15. The average yield at the April 2021 bond was 5.545% compared with 5.433% on Oct. 20, below secondary market levels." This morning, we also have generally falling yields in Europe.

The first thing I thought of when I heard of this was that banks are doubling down on their bets.

As I described in my last post, the ECB has made available a LTRO (Long Term Refinancing Operation) Facility, through which banks can post collateral in order to obtain funds at 1%. This is not the first time they have done this. In 2009, the ECB conducted similar programs. If you read the link at FTAV, you can see that some feel that these programs may have contributed to the banks loading up on high yielding, long dated peripheral sovereigns as part of a carry trade. Banks borrowed for one year at 1% from the ECB, bought longer dated PIIGS bonds with higher yields (the short dated bonds were not yielding enough at the time), and made the interest spread. About half of the program's 614 billion euros are estimated to have been invested in sovereign debt, mostly from Greeece and Spain, according to the FT. What banks did with the bonds once the first LTRO facility closed is an open question, but undoubtedly many remained on the banks' HTM books.

Well, now were at it again. As popularized by French ~~Whack-Job~~ President Sarkozy, the idea would be that banks can again use this money to gain an interest spread on sovereign debt, thus supporting bond prices.

French President Nicolas Sarkozy said the ECB's increased provision of funds meant governments in countries like Italy and Spain could look to their countries' banks to buy their bonds.

"This means that each state can turn to its banks, which will have liquidity at their disposal," Sarkozy told reporters at the summit in Brussels. (RT)

Next Tuesday, the LTRO will hold its first auction, and markets will be watching closely to see how well the offering is subscribed. As mentioned, this time the term will be for three years as opposed to one, at a rate of 1%. This is the just first leg of a three pronged liquidity program. Secondly, the type of collateral that can be offered to the ECB in return for these loans has been widely broadened, to include non-securitized, non-rated loans. To quote Draghi, "Our second measure will allow banks to use loans as collateral with the Eurosystem, thereby unfreezing a large portion of bank assets. It should also provide banks with an incentive to abstain from curtailing credit to the economy and to avoid fire-sales of other assets on their balance sheets." Thirdly, reserve requirements will be halved. "The third measure we announced last week is to reduce the required reserves ratio from 2% to 1%. This measure frees up liquidity of the banking sector by about 100 billion euro. Along with other measures, this reduction in the reserve requirements should, too, help revive money market activity and lending." Beyond these announced measures, we also have this little gem from MNI this morning, in which the ECB is advocating for a delay in the implementation of Basel III capital ratios,

So, banks are now given the opportunity to borrow against almost any asset they hold in order to potentially buy sovereign debt, all while reducing reserve pools and avoiding capital raises. Sounds like doubling down to me.

The big question is - will they take the bait?

In answer, it appears that some already have. I find it hard to explain the results of yesterday's Spanish auction otherwise. (If you have an alternate explanation, please post it in comments.) Some speculate that it will largely be the smaller and medium sized banks that might participate in this Martingale carry trade. A good article dealing with this question can be found in the FT, titled Doubts over ECB move to boost bond sales. I won't rehash that here, but highly recommend you read the article.

IF this trade does develop as Sarkozy hopes it will, I can see several potential pitfalls, beyond the obvious one of doubling down on very volatile and risky assets. Firstly, such a trade would only be attractive to European banks. This would serve to concentrate risk within the Eurozone, and may present non-European banks with an attractive opportunity to sell remaining European sovereign debt holdings. Remember, these non-European banks have been tolerating default risk to hold this debt. Now, they appear to be facing currency risk as wwell. Secondly, banks would very likely be "encouraged" to buy the debt of their own sovereign. This could serve to repatriate sovereign debt and compartmentalize risk within individual Eurozone countries, and may not be a bad thing if a dismantlement of the EMU occurs. On the other hand, such domestic preference could lead to selling pressure from non-domestic EMU banks, in addition to the selling pressure from non-European banks mentioned above. Finally, what would such a re-leveraging into volatlle assets mean for bank ratings?

ECB repo extension a fillip for sovereigns

You Can Bank on It: European Banks Need Tons of Money

Banks resist European pressure to buy government debt

Bass-Ackwards QE

2011-12-14T21:14:00.000-05:00

Rik made mention of a very current and important topic regarding last week's announcement of 3 year unlimited collateralized loans that the ECB extended to banks. Ostensibly, this was to preserve liquidity. However, there has been some discussion of how it could turn into a form of QE.

FT Alphaville has done a post about this, and so did John Hussmann.

. In relevant part,it reads:

"We've seen some theories that Europe intends toaddress the problem through ECB lending to banks, taking distressed debt ascollateral, with the banks turning around and buying more distressed debt.Apart from the fact that this would be the sort of "legal trick" thatthe ECB would be unwilling to facilitate, this would imply an increase in bankleverage ratios far beyond the 30-40 multiples that already exist (which wouldbe a disaster when tighter Basel III capital requirements kick in). In practice,depositors would flee, and you would end up with a European banking systemwhere bank bondholders, not the ECB, would be subject to the losses, since theECB's collateral claims would be senior. Likewise, IMF loans are always highlyconditional, and are always senior claims."

I agree with Hussmann's assessment. This would really be ass-backwards QE, IF ithappens. With the FED, the PD's buy thebonds, and then the FED buys them in the secondary market from the PD's. In the end, it is the FED, with its"infinite" balance sheet that becomes leveraged. In the SARKO variety, the ECB extendsnon-loss bearing loans to banks which then have to lever up their own balancesheets even more to buy these instruments. In the FED case, bank get capital injections and the CB gets HTMpaper. In the ECB case, banks take onsenior loans, offering very volatile sovereign paper as collateral. As Rik mentioned, this is real last Euro lottery there, - or Russian Roulettewith five rounds in the chamber.

Other issues this raises are how much exposure this gives the ECB to crappy collateral? FTAV has a related post here. What kind of haircut is the ECB giving to hold this collateral? How much of this borrow-buy carry trade is actually taking place, and which banks are involved? What effect would further margin requirement hikes by the likes of LCH Clearnet have on this situation? How will this kind of leverage affect the other market activities of the broker dealers? (see FTAV)

Sarkozy plan to prop up sovereigns is worrying (FT)

I'll leave you with a link to a post on a great Australian Macroeconomic Blog I found: France is next

At the Risk Of Extreme Embarassment...

2011-12-14T18:16:00.002-05:00

This count feels like it came out of one of my orifices sideways given what I see in Europe. Nevertheless, it is what I am looking for, and, if its right, it should start without delay. Target ranges for the top of (2) are given in aqua.

RUT 60

RUT 10

RUT 1

SPX 10 MIN

DAX Close & EUR/USD

2011-12-14T11:49:00.002-05:00

If this was a falling bullish wedge, it ought to be close to finished. From here, a thrust up to double top for (2) could be in the cards.

DAX 60

DAX 10

The EUR/USD is nearing triple fib confluence support on the weekly chart.

EUR/USD WEEKLY

Still in [b]?

2011-12-12T20:22:00.001-05:00

Hard to post any kind of a bullish count after what we observed on Friday, but I have a hard time constructing a reasonable looking truncation of Minor Z of (2) just yet. My current thought runs toward an expanding triangle of [b] of Z.

DAX WEEKLY

DAX 60 MIN

DAX 10 MIN

RUT 60 MIN

RUT 10 MIN

EUR/USD

8 HOUR FIB CONFLUENCE RESISTANCE

Jens Weidmann Gets It

2011-12-12T13:25:00.000-05:00

Jens Weidmann

A quote Jens Weidmann, the German Bundesbank President gave to the Frankfurter Allgemeine Zeitung (FAZ) on 12/10/2011: "The crisis summit has confirmed: the solution to the crisis is the responsibility of Governments, on reforms in the country and if need be of aid to other countries. The mandate for a redistribution of funds between the taxpayers of Member States is clearly not with monetary policy. Financing of public debt via the printing of money is and will remain contractually prohibited."

Do you understand what he is saying? Unlike the Fed and the BoE, the ECB is the central bank to multiple sovereign nations in a currency union. While the Fed and the BoE may establish policy that transfers resources from one group to another within a sovereign nation, the ECB potentially could cause these transfers to occur between sovereign nations. The treaties establishing the currency union were quite explicit in preventing the union from evolving into a transfer union. Per Weidmann, it is NOT up to the ECB to overturn the spirit and the letter of those founding treaties. If the politicians and their electorates wish to establish a formal transfer union, it is the responsibility of elected governments to make that happen. The ECB is NOT going to bring about a transfer union by fiat!

Some would call this type of attitude naive. "This is no time for principles - the market is crashing for God's sake!" "Weidmann, you are such a boy scout!" (see clip below)

Personally, I offer a salute of respect. If the politicians really want a transfer union, let them broach the subject to their electorates. Don't abdicate the responsibility for such a momentous decision to unelected monetary officials.

Pegged [EDIT 1]

2011-12-09T21:23:00.001-05:00

BLANKFIEND'S BULLSHITE-O-METER

I could actually end my commentary regarding the EU summit (full statement) results right here, but I'll expound. Several areas to discuss.

1. The new "fiscal pact:" Perhaps the Who said it best in their song "Won't Get Fooled Again:"

But the world looks just the same

And history ain't changed

'Cause the banners, they all flown in the last war...

This pact is a rehash of the old, failed Stability and Growth Pact, except it will lack the legitimacy of an EU level treaty. It is supposed to forced governments to adopt a constitutional level balanced budget amendment. The adequacy of that amendment is subject to review by the European Court of Justice, which will not have jurisdiction to hear the case given that this is NOT going to be an EU level rule. Furthermore, it seeks to impose automatic penalties on countries exceeding debt and deficit targets, and looks to give bureaucrats in Brussels the ability to disapprove of national debt issuance programs ex ante. Again, without the power of a Treaty, this seems to me to be completely unenforceable. (Read "Questioning the Legality of a Separate Euro Treaty" in Der Spiegel.) Many similar provisions were found in the Maastricht Treaty, which had legal legitimacy, and they were never enforced. How are we to believe they would be now? Beyond that, it is a misnomer to call this a fiscal pact. Rather, I would call it an austerity pact, as all it seeks to do is impose budgetary discipline without any reference to a common tax policy, intergovernmental revenue sharing, or a common fiscal authority. Most importantly, this measure does absolutely nothing to address the immediate solvency problem in sovereign debt markets. It reminds me of the lung cancer patient who decides to stop smoking, but declines any other treatment. Nice gesture, but you still end up dead.

2. The EFSF/ESM provisions:

a. Funding: The agreement seeks to pull forward approval of the ESM into July of 2012, but leaves the combined ceiling of the two programs at 500 billion euros - subject to reassessment in March 2012. No mention is made of recalculating the capital contributions from member states, which would leave Germany and the other AAA's with grossly larger obligations given the fiscal status of Italy, Spain, and others. Perhaps the thought here is that the ESM has the legal status to request loans from the ECB? Whether it would get them is another question. Regarding the EFSF, mention is made again of leveraging the EFSF expeditiously using one of the two ~~Ponzi~~ schemes decided upon on 29 November. Unfortunately, given the way EFSF bond sales are going, and the dim prospects for France, and perhaps Germany, to maintain AAA status, leveraging the EFSF looks dead in the water to me.

b. ECB Role: IMO, what the market is truly counting on is this statement: "We welcome [beg] the readiness of the ECB to act as an agent for the EFSF in its market operations." Given the very limited additional monetary firepower this accord commits to backstopping sovereign debt, this is undoubtedly one of the major goals of this Summit - to get the ECB to start printing. Draghi actually rolled his eyes during a press conference when asked about this, reaffirming that this is not the role for the ECB. Draghi seems to be a man who respects the sacrosanctness and fragility of the ECB's credibility. A recent quote is telling: "Gaining credibility is a long and laborious process. Maintaining it is a permanent challenge. But losing credibility can happen quickly - and history shows that regaining it has huge economic and social costs." A December 9 FT article said the following: "In a press conference following a meeting of the ECB’s 23-strong governing council in Frankfurt on Thursday, Mr Draghi stressed the limited role prescribed to the central bank by European treaties and their ban on central banking funding for eurozone governments. Not just the letter, but the “spirit” of the treaties had to be respected, he insisted repeatedly."

c. Voting Rule Changes: In a slight of hand designed to avoid the embarrassing squabbles of flea-sized countries like Slovakia and Finland, the ESM will no longer require unanimity in decision making. Instead an 85% "qualified majority" will do. This immediately brought about Finnish objections, with headlines from a Finnish paper reading Finland threatens to leave bailout fund over unanimity row. The whole quote is worthwhile, as it portends what is to come from other small countries, like the Netherlands and Slovakia. "Finance Minister Jutta Urpilainen on Friday said Finland would leave the EU’s bailout fund if decisions on it are no longer made unanimously. She said Finland will drop out if a Franco-German push to take decisions on future bailouts by a supermajority goes ahead. Urpilainen said the government’s decision on the matter was unanimous. Finland has maintained that it cannot agree to transitioning from decision making by unanimous consent to a system where voting rights are based on holdings in the European Central Bank. The Franco-German proposal would allow countries holding 85 percent of the European Central Bank’s capital to push through decisions on the European Stability Mechanism (ESM). France and Germany have lobbied for qualified majority voting to avoid being taken hostage by small countries, such as Finland. On Thursday, a Finnish parliamentary committee ruled that agreeing to supermajority voting is unconstitutional and encroaches on Finnish sovereignty." Blankfiend observation: Either Urpliainen was in the bathroom taking a piss when they blissfully all agreed on this provision, or perhaps the warrants of solidarity advertised as having been present for the accord are less than factual. [EDIT: Thanks to reader Tavis for pointing out that this voting change rule was clearly indicated to be dependent on Finnish Parliament approval. Given the reaction in the Finnish press, it seems that the Finns never had any intention of approving the rule change, so why it made it into the final summit release is a good question.]

3. The IMF contribution: Within 10 days, member states or their NCB's are to put together a fund totalling up to 200 billion euros. These funds would then be loaned on a bilateral basis to the IMF. "We are looking forward to parallel contributions from the international community." In the end, this initiative is simply another effort by relatively rich Europe to get OPM (other peoples' money) to solve their internal problems - another thinly veiled plea to China, Brazil, etc... The US has already said it will not participate, and this may set the tone. If this IMF fund remains at 200 billion, it's chump change.

4. The End of PSI: This little paragraph is a masterpiece of meaninglessness and deception. It refers to adhering to "well established IMF principles and practices" regarding private sector bail-ins, and implies that decisions "concerning Greek debt are unique and exceptional...." Evidently, this is supposed to reassure private sector holders of European sovereign debt that they will enjoy preferred creditor status and never have to suffer losses in the event of restructuring. By inference, if the private sector will not have to suffer loss, that would mean that the public sector - the EFSF/ESM, ECB and IMF - would. Apart from pledging that taxpayers will absorb first losses on EFSF/ESM holdings, this is utter bullshit. Public sector debt holders are super senior and will not bear loss while private sector holders are made whole - not going to happen, period! Regarding the "well established IMF principles and practices," those simply codify that it is the private sector debt holder that absorbs the first loss, and the IMF never does. This is why foreign nations put money into the IMF - they count on getting their money back. Even the implied pledge to have taxpayers take losses ahead of the private sector for EFSF/ESM commitments hardly seems politically credible. When the shit hits the fan, I'd like to meet the politician who will be able to tell his/her people that they are going to pay for the losses ahead of the banks/foreign sovereign wealth funds/Japanese insurance companies. To add insult to injury, the same paragraph goes on to say "standardised and identical Collective Action Clauses will be included, in such a way as to preserve market liquidity, in the terms and conditions of all new euro government bonds." As you probably know, a Collective Action Clause, or CAC, "allows a supermajority of bondholders to agree a debt restructuring that is legally binding on all holders of the bond, including those who vote against the restructuring." Remind me please - how do the inclusion of CAC's in future debt issuance reassure private bond purchaser against being bailed-in during a restructuring??? Most importantly, the greater the degree to which the non-loss-bearing super senior funds of the IMF or the ECB are used for bond purchases, the greater will be the need to impose losses on the junior (read "private sector") debt holder in order to achieve any meaningful debt restructuring.

___________________________________________________________________________________

Despite my opinions, many are heralding this EU summit as some type of historic breakthrough. Two of the local papers here had headlines that read "EU Fiscal Union Forged," and "EU Forges Fiscal Union, Sees Way Through Crisis." The equity market crackheads certainly gobbled it up, despite the fact that Italian and Spanish bond yields initially spiked on the news until being driven back down by the ECB. The whole affair reminds me of Hans Christian Andersen's "Keiserens nye Klæder," or Emperor's New Clothes. If you recall the tale, no one wanted to look foolish by declaring that the Emperor was naked, as only "the unusually stupid" could not see these fine robes. Will the ratings agencies be similarly deluded? Only after a child declared "But he hasn't got anything on," were others brave enough to acknowledge the truth.

I'll opt for the role of the innocent child on this one. Perhaps I have some company....

The markets didn’t just vote on the Euro summit

Europe’s disastrous summit

The gap between summit rhetoric and reality

Questions Plague EU Pact

Eurozone leaders deluded if they think this 'sticking plaster' treaty can solve the debt crisis

A Summit to the Death
"The world nowadays looks very much like the theoretical world that economists have traditionally used to examine the costs and benefits of monetary unions. The eurozone members’ loss of ability to devalue their exchange rates is a major cost. Governments’ efforts to promote wage cuts, or to engineer them by driving their countries into recession, cannot substitute for exchange-rate devaluation. Placing the entire burden of adjustment on deficit countries is a recipe for disaster.

In such a world, fiscal union is an essential counterpart to monetary union. If the gumbo industry goes into decline, driving the US state of Louisiana into a recession, residents will pay fewer federal taxes and receive more fiscal transfers. These financial flows are a natural counter-cyclical mechanism that helps local and regional economies to weather bad times. In a hypothetical European fiscal union, there would certainly be transfers from Germany to the periphery in 2011, but a properly designed setup would have ensured flows to Germany in the 1990’s, as it struggled to cope with the costs of reunification with East Germany.

With this in mind, the most obvious point about the recent summit is that the “fiscal stability union” that it proposed is nothing of the sort. Rather than creating an inter-regional insurance mechanism involving counter-cyclical transfers, the version on offer would constitutionalize pro-cyclical adjustment in recession-hit countries, with no countervailing measures to boost demand elsewhere in the eurozone. Describing this as a “fiscal union,” as some have done, constitutes a near-Orwellian abuse of language."

The summit to end all summits

ciaranohagan-oct252011

Inflection Point

2011-12-08T20:33:00.001-05:00

A brief count update tonight. We are clearly in the sweet spot for a bullish reversal into [c] of Z. Much depends on the DAX finding support tomorrow morning in the 5760 range. Another major contributor would be a sharp short squeeze in Euro shorts, which there are in near record numbers. See my earlier post today for EUR/USD.

DAX DAILY

(at the 50 dma)

DAX 60 MIN

DAX 10 MIN

(Earlier projection lines still apply)

RUT DAILY

RUT 60 MIN

RUT 10 MIN

I'm too tired to opine prolifically on the possibilities for the latest ~~clown show~~ summit, but I do expect one more marvel of financial engineering and imagination to evolve, probably involving the IMF establishing a European Monetary Fund, which would then get funding from the NCB's. Some type of agreement on using the EFSF to recap banks would also not surprise, even though the EFSF is actually an UNFUNDED entity that relies on callable capital and funds itself through bond sales. (Bond sales that have not gone well lately, BTW). Beyond that, maybe some more hype about pulling the ESM implementation forward by a year. Just for grins, here is the capital subscription key for the ESM, as agreed in July of 2011. Remember, unlike the EFSF, the ESM is funded with actual hard money contributions. Pay attention to the amounts expected from the highlighted countries, particularly Italy, Spain and France. Not counting France, the highlighted countries are 35% of the total capital stock.

WACH AUF DEUTSCHLAND!!!

Short the Euro? WATCH OUT!!!

2011-12-08T12:57:00.001-05:00

Yesterday night, I posted the following:

EUR/USD: I generally do NOT EW count currencies, but sometimes it can be useful on shorter time frames just to illustrate expectations. What I am imagining for this pair is a possible running converging triangle that completes in the European morning, leading to a subsequent swift thrust down to test the .786 retrace near 1.3283. That could give us the (c) wave I am looking for to complete [b] of Z in equities.

EUR/USD 1 HOUR

The update to that chart looks like this.

EUR/USD 1 HOUR

Given the near record short positions in the Euro, a rapid and violent short squeeze is a distinct possibility here.

Furthermore, given the 0.8 correlation between the Euro and equities, we may be getting very close to the end of that [b] wave.

RUT 10 MIN

I would not be surprised if we see no announcement from the EU summit tomorrow. At this point, I am looking for them to continue meeting into the weekend, after which they may pull out yet another short-lived marvel of financial engineering designed to try and use OPM (other peoples' money) to solve their problems.

More later....

Looks Incomplete

2011-12-07T20:18:00.001-05:00

Just a short count update to what I posted yesterday. Although both the DAX and the RUT put in impressive declines and recoveries today, the decline does not look complete in Fibonacci or time symmetry terms.

DAX: a speculative projected path is shown. Still looking for a test of support at 5760, perhaps after an opening bounce tomorrow morning.

DAX 10 MIN

RUT: the decline put in today reversed at exactly the .236 fib line of the recent advance. This is usually not a significant fib level, and the duration of the correction still seems too short to call a completed [b] wave yet. Looking for a test of support near 719 and the .382 retrace before [b] is over.

RUT 10 MIN

RUT 1 MIN

EUR/USD: I generally do NOT EW count currencies, but sometimes it can be useful on shorter time frames just to illustrate expectations. What I am imagining for this pair is a possible running converging triangle that completes in the European morning, leading to a subsequent swift thrust down to test the .786 retrace near 1.3283. That could give us the (c) wave I am looking for to complete [b] of Z in equities.

EUR/USD 1 HOUR

IN-CREDIBLE! (Edit 1)

2011-12-06T19:24:00.001-05:00

As in not credible, as opposed to wonderful. European leaders' latest ploy is to have us believe that they are going to lay the groundwork for a Treaty change that will enforce fiscal discipline throughout the Eurozone. This time they are SERIOUS, as opposed to when the approved the same provisions in the Maastricht Treaty a decade ago. This time, offenders will be automatically penalized. Any nation which cannot get its deficit under control will owe yet more money in fines, enforceable by ??. Furthermore, all governments will have to have balanced budgets (at least until the next crisis....)

Now, based on these new "pinky promises," the consensus view is that the ECB will step in very aggressively to set a ceiling on Italian and Spanish yields. The logic is obvious and compelling - how could the ECB just sit there and preside over its own demise, right? The fact that such a move would likely be illegal, would jeopardize the credibility of the ECB, and would establish tremendous moral hazard is discounted. "It's not pretty, but it's got to be better than letting the Eurozone go under, right?" From what we have seen so far in the negotiations over Greek debt, bonds held by the ECB would likely be senior debt, with private sector held bonds being immediately subordinated. Oh, I forgot, the EU leaders also pinky promise that the private sector will no longer be at risk in any default scenario. "Don't worry! We'll be happy to have our domestic taxpayers absorb the losses on that foreign debt. Seriously!" (Edit: BTW, if the ECB chooses to go down this path, it needs to go all in right up front. Otherwise, the market will test its resolve.)

However, we won't stop there. Leaders also hatching a scheme to bring forward the implementation of the permanent European Stability Mechanism (ESM). The EFSF is failing rather miserably, is at great risk of a ratings downgrade, and is also ineligible for direct loans from the IMF (as it is a Luxembourg based corporation). The ESM, on the other hand, would be eligible for IMF loans. In contrast to the EFSF, which is funded based on promises (callable capital), the ESM will require that Eurozone countries actually start ponying up real money. This has been floated before, but, like any good, self-respecting TURD, has risen to the top of the bowl again. I discussed this very idea on October 23rd, and I will reprint my comments here.

"A final scatalogical remark, regarding the dog and pony show to rescue the Euro. The market rallied on Friday because someone suggested that the European Stability Mechanism (ESM) could be brought forward and combined with the European Financial Stability Fund (EFSF). As you (should) know, the EFSF is the temporary measure with 440 billion of lending capacity and funding via callable capital guarantees. The ESM is the permanent mechanism that was to replace the EFSF in 2013, and would have 500 billion of lending capacity funded by paid-in capital. It is quite clear from the ESM Treaty that the ESM was never supposed to be additive to the EFSF, as you can read below:

TRANSITIONAL ARRANGEMENTS

ARTICLE 34

Relation with EFSF lending

During the transitional phase spanning the period from June 2013 until the complete run-down of the EFSF, the consolidated ESM and EFSF lending shall not exceed EUR 500 000 million, without prejudice to the regular review of the adequacy of the maximum lending volume in accordance with Article 10. The Board of Directors shall adopt detailed guidelines on the calculation of the forward commitment capacity to ensure that the consolidated lending ceiling is not breached.

__________________________________________________________________________________

Changing this restriction to make the two programs additive would:

1. Require approval in all 17 Parliaments again (ain't happening)

2. Nearly double the budgetary bailout commitments of Eurozone sovereigns, to include Italy, Portugal/Ireland (which do not pay into the EFSF, but are slated to contribute to the ESM), and FRANCE!

3. If combined with a 50+% haircut on Greek debt and a substantive government funded bank recapitalization, could be enough to cost France its AAA."

The only real differences between when I made those remarks and the present are:

Many more nations than just France are at risk of losing their AAA. These ranks now include Germany and Holland. France itself looks more like a two-notcher.
Italy and Spain look even less likely to be able to contribute actual money to the ESM.
The Greek haircut is going to be well over 50%. In fact, I think the private sector holders are going to get wiped out, zero, bupkis.

Let's see, what else? We also have talk of the IMF coming in to provide emergency funds to the Eurozone. Remember, the IMF loans money to governments, government entities, and national central banks. They do not buy bonds, and any loans they make are super senior debt. But, the real problem is that the IMF does not have enough money to amount to much more than "chump change" (h/t Stephen Roach, MS) viz-a-viz the amounts of sovereign debt that need to be backstopped. Of course, there is talk of the ECB somehow loaning the money to the IMF to increase its firepower. Even the Fed was mentioned as a possible participant in funding the IMF, although Geithner denied that today. As far as I know, the USA's latest pledge to the IMF has not actually been funded by Congress, which should be quite the circus to watch if we go down that particular road.

Whatever the case, I would summarize the situation as follows: European leaders are making incredulous promises regarding financial discipline in order to draw supra-national funding. Any supra-national funding source that does contribute is going to have super senior status, regardless of any promises to private sector bond holders (see here). Looks to me like a great opportunity for private sector bond holders to unload...

As to markets, we are obviously not in (3) of [C]. My count has us now in Minor Z of Intermediate (2). I'll illustrate with the DAX and the RUT.

DAX: The 10 minute chart gives a projection. It presumes that a five wave [a] of Z has concluded, and that [b] is in progress. Support for [b] is strong at the .50 retrace of [a], near 5760. Assuming a rebound from ~5760, [c] would be equal to [a] very near the .618 retrace of Intermediate (1), around 6550. That would mark the top of (2).

DAX DAILY

DAX 60 MIN

DAX 10 MIN

RUT: Again, the 10 minute chart tells the story. A five wave [a] of Z is over, [b] should find lateral support around the .382 retrace of [a], around 717.x. From there, [c] would be .618 of [a] around 779, which would also be the .618 retrace of (1). However, this is sort of no-man's land as far as lateral resistance. [c] would equal [a] at ~809, which would be more like the .786 retrace of (1), and a much more promising lateral resistance level.

RUT DAILY

RUT 60 MIN

RUT 10 MIN

The obvious fly in the ointment with either of these counts is that they put the DJI at great risk of making a new recovery high, particularly if the RUT makes it all of the way to 809. So, maybe we see less rebound than I am projecting - Z does NOT have to exceed Y in (2). Alternatively, I could just be completely wrong about the longer term count. Wouldn't be the first time...

Recommended Read: Moral hazard will result from ECB bond buying (Otmar Issing the FT) A much more nuanced article than the lousy title suggests. Contrasts the legitimate role of a central bank as a lender of last resort with the very dangerous role of being the ultimate buyer of sovereign debt.

EDIT: Another Recommended Read: Winning the European Confidence Game (Raj Rajan) An excellent discussion of the lack of loss bearing capacity of supranational funding, be it from the ECB or the IMF.

What Was That All About?!?

2011-11-28T19:43:00.001-05:00

Very strong up day today, but the quandary I presented in the RUT yesterday is still unresolved. My two counts are shown on the 30 minute chart.

RUT DAY

RUT 60 MIN

RUT 30 MIN

The DJT is shown to give the bigger picture view. Unlike the RUT, it did retrace to .618 of its Intermediate (1) decline, and it did test and reject at its 200 DMA.

DJT DAY

DJT 60 MIN

DJT 10 MIN

The German DAX had a very impressive day today. It rose enough to challenge an open gap and almost touch its 50 DMA. Of the three indices I am showing, it has a valid triangle in the green count on the 60 min chart. The DAX also never got that close to testing its 200 DMA. Is that what it is trying to do now? I doubt it, but the next few days should be very telling one way or the other.

DAX DAILY

DAX 60 MIN

DAX 10 MIN

The final chart shows some near term DAX fib resistance levels. The two thick horizontal bars represent confluent resistance levels.

DAX 60 MIN FIB RESISTANCE

So, what was today's rally all about? Possessed, maniacal shoppers pepper-spraying each other? Don't think so. The latest idea is that Germany and France will be able to ram through fiscal discipline pacts that Eurozone governments will mutually agree to without the democratic nuisance of pursuing Treaty change. Based on these pacts, the ECB will then step in and start monetizing. Hey, who knows? If the ECB is truly wanting to go in that direction, and just looking for political cover, then maybe these "pacts" will do the trick. Just one question though - did not the TFEU already contain Treaty level agreements setting debt and deficit maximums in Article 126 and Annex? My Bullshit Meter is pegged at 101%.

To those who made some very nice remarks concerning my father, I thank you. To those who feel they would like to make such remarks, I ask you to please refrain, as I really don't know how to respond.

What Might the Count Be?

2011-11-27T21:09:00.001-05:00

I am still torn, and present three options. I'll use the RUT, as usual. The black count shows a completed second Minor X of (2). The red looks for a smallish (iv) wave of [iii], and seems too early. The magenta would imply a more substantial rally, possibly closing the gap at 717, which is also the .618 retrace of (i) of [iii].

RUT 30 MIN

The EUR/USD may have just finished a bullish falling wedge. Triple fib resistance exists around the lateral resistance level of 1.384, and a reversal there would be consistent with my magenta RUT count. Beyond that, we have significant resistance at the 1.455 level, which would go along with my black RUT count.

EUR/USD 4 HOURS

EUR/USD 2 HOURS

TNX has been continuing sideways, despite all of the recent European turmoil. This has really kept me on my toes as to the possibility of the black X count. Again, the 22.35 level would be an ideal place for a medium term bullish reversal in 10 year prices.

TNX 60 MIN

TNX 10 MIN

Much Barosso About Nothing - Link

2011-11-27T17:38:00.001-05:00

Please see my earlier post by this title. I was working on it when I got the news about my Dad, and so it ends up earlier in the publication order than I would have liked.

In Memory of My Father

2011-11-25T23:19:00.001-05:00

I have been out of touch for this past week as I was down in Florida visiting my father James. On a family trip down there in April, I noticed that Dad was having difficulty swallowing. We took him to the ER, and he had huge lymph nodes in the center of his chest that turned out to be lymphoma. This was his second round of lymphoma, having successfully been cured of a previous occurrence ten years prior. He promptly started chemotherapy, but was unable to finish due to low white blood cell counts. Two weeks ago, he fell in his apartment and was taken to the hospital, where a chest X-ray showed fluid around his lungs. That fluid turned out to be a malignant pleural effusion due to his lymphoma, and that news robbed my Dad of any will to fight on. Before he died, all of his kids, and my kids, got a chance to see him while he was still fully alert, and for that I am forever grateful.

My Dad was a "Mainer," born in Belfast in 1924. He served with the US Army as a firing battery commander in direct support of the Marines on Iwo Jima, and later served a tour in Vietnam in an Artillery role as well. It was there that he had exposure to Agent Orange, which probably was the cause of both of his bouts of lymphoma. He retired in 1974, and in 1990, he and my Mom moved to Sun City Center, Florida.

He was the best father a son could ever want. Tonight, he is with God and his beautiful bride Eleonor, who preceded him almost four years ago.

Much Barroso About Nothing

2011-11-25T17:09:00.001-05:00

Most of the time, there is a force that prevents the inconceivable from becoming the inevitable. That force is weakening.

I refer to the situation in the EMU, which is becoming more dire by the day. We have already discussed some of the options the EMU has half-heartedly tried in order to stem this crisis. The idea of levering the EFSF I have discussed many times, here, here and here. The markets seem to now recognize that a levered EFSF without ECB guarantees is not going to happen. We have also discussed the idea of the ECB as LOLR, here and here. So far, the ECB and Germany are resolute in avoiding this role for the ECB. The latest development has been the release of a "green paper" by the European Commission discussing the feasibility of Stability Bonds (aka Eurobonds).

The paper discusses three principal options for the issuance of these bonds:

"The many possible options for common issuance of Stability Bonds can be categorised in three broad approaches, based on the degree of substitution of national issuance (full or partial) and the nature of the underlying guarantee (joint and several or several) implied. The three broad approaches examined in the Green Paper are:

the full substitution by Stability Bond issuance of national issuance, with joint and several guarantees: this approach would seem the most ambitious option of all, as it would replace the entire national issuance by Stability Bonds and as each Member States would be fully liable for the entire issuance. This option would accordingly have strong potential positive effects on stability and integration. But at the same time, it would, by abolishing all market or interest rate pressure on Member States, pose a relatively high risk of moral hazard and it might need significant Treaty changes.
the partial substitution by Stability Bond issuance of national issuance, with joint and several guarantees: this approach would essentially be the same as the option mentioned above, but Stability Bonds under this option would only cover parts of national financing needs. Therefore, Member States would continue issuing their own bonds, although at an accordingly lower volume due to the parallel issuance of Stability Bonds. Hence, Member States would still need to tap financial markets on their own and would be subject to market and financing conditions that would vary across Member States and might reflect their different credit quality. Hence, the risk of moral hazard would also exist under this option but in a more reduced form. As this approach would only partly cover financing needs of Member States, under this approach, as under the third one, one would have to decide about the specific volume or share of financing needs for a Member State to be provided by the issuance of Stability Bonds.
the partial substitution by Stability Bond issuance of national issuance, with several but not joint guarantees: This approach is the most limited one of the three options, as it would only partially cover Member States' financing needs (as Approach No. 2 above) and as it would only be covered by several guarantees. This option would therefore probably have only smaller effects on stability and integration, and the risk of moral hazard for the conduct of economic and fiscal policies in Member States would seem very limited. This option would be relatively rapidly deployable, as the need for measures to counteract such moral hazard would be limited and as the instrument seems also otherwise fully compatible with the Treaty. To ensure a sufficient creditworthiness of such instruments, some additional safeguards, i.e. "credit enhancements" might be necessary, for example in the form of collateral provided by Member States. This approach would have certain similarities to bonds issued by the European Financial Stability Facility (EFSF). However, whereas the latter are meant to step in and help financing vulnerable Member States in the context of the sovereign debt crisis, Stability Bonds would be instruments available to all euro area Member States and also outside any crisis context. Their volume and potential effect on market efficiency and integration would be accordingly much larger."

The EC provides a nice table to summarize these three options, which I show below:

I would like to make several points about these three options, without regurgitating what the EC has said. Before doing so, I want to remind you of the difference between joint and several liability. Joint liability implies that the each country within the EMU would be individually responsible for the entire amount of an obligation issued under a Stability Bond. If Italy could not pay its share, then Germany would be obliged to cover the shortfall. Several liability implies that each country would be responsible for a pro-rated share of the obligation, determined by some type of capital key structure. For example, if a 100€ stability bond was issued, and Germany's capital key was 30%, then Germany would be on the hook for 30€ if the bond was to default.

On to my points of discussion...

Joint and several liability for EMU wide debt issuance would most definitely require a Treaty change, as it violates the no-bailout clause of Article 125 of the Treaty on the Functioning of the European Union (TFEU). In relevant part, the treaty states: "A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project." Furthermore, joint and several liability would be in violation of the German Constitution, as recently interpreted by the Karlsruhe Court. Specifically, they stated: "When establishing mechanisms of considerable financial importance which can lead to incalculable burdens on the budget, the German Bundestag must therefore ensure that later on, mandatory approval by the Bundestag is always obtained again. In this context, the Bundestag, as the legislature, is also prohibited from establishing permanent mechanisms under the law of international agreements which result in an assumption of liability for other states’ voluntary decisions, especially if they have consequences whose impact is difficult to calculate." The current crisis simply does not allow time for changes to the TFEU and the German Constitution. IMHO, this rules out the option of joint and several liability, thus ruling out options 1 and 2.

The second option has been proposed before. In its earlier reincarnation, it took the form of "blue" Euro-area bonds, which would be jointly and severally issued up to 60% of a country's GDP, and red national bonds, which would be issued by the countries themselves to cover the remainder of their debt. Besides being a non-starter for the reason I put forward in #1 above, the blue bonds would subordinate the red national bonds, immediately causing red bond yields to soar. As you can see from the graph below, France, Italy, Spain, Portugal, Greece, Belgium, and Ireland would have too large a portion of their debt subordinated and paying higher yields to have the benefits outweigh the costs of such a scheme.
The second option also raises the issue of issuance ceilings for the blue bonds. A figure of 60% of GDP is often cited, as this is what the TFEU says should be the maximum allowed debt/GDP ratio of member states. Think about this for a second. The Treaty guidelines for debt/GDP ratios have already been violated by all but five members of the EMU, as the graph above shows. Are we now to believe that a credible hard ceiling could be set and enforced for blue bond issuance? If a large country like France was hard up against its blue bond ceiling and faced calamity if it had to turn to red bond issuance, would the ceiling be enforced? In my mind, the second option would quickly reach the point where it would either collapse or morph into the first option with full joint and several issuance. Hence, the second option is merely a sucker's play to get low-yield countries to go along with what would inevitably turn into a full blown debt union with joint and several guarantees of all sovereign debt issuance.
Option 3, severally guaranteed bond issuance, is merely national issuance under a new name. It really differs very little from the current severally guaranteed EFSF bond structure, except that it would not be restricted to crisis funding. The one thing that it could do is give the ECB some very thinly veiled cover to begin the kind of massive debt monetization that so many pundits are calling for. Whether the Bundesbank would fall for such a rouse is highly questionable, although we have to remember that the Bundesbank does NOT have veto power at the ECB - it has just one vote. Maybe I am missing something else here, but I fail to see how severally guaranteed bonds would in any way alter the current crisis.
Any type of joint bond issuance, whether it would be under option 1 or 2, would require the establishment of credible supranational agencies to issue debt and, more importantly, to ascertain how much debt given member states could issue in any particular period. Necessarily, this would require the ceding of a great degree of national fiscal sovereignty to the supranational EU level. I find such a massive abdication of national sovereignty highly unlikely in the present European political environment. In the debtor nations, like Greece and Italy, we have already seen violent protests and resurrection of post-war hatreds over what is seen as German interference in national affairs. In the creditor nations, such as Finland and Germany, we see the beginnings of strongly nationalistic movements with a distinctly anti-European flavor. I do not feel that joint issuance is politically possible in today's Europe. The idea will not fit through the Overton Window.
The final point I would like to discuss is theoretical yields for these three options. Several issuance (Option 3) would probably not alter the current yield picture. If you think it would, I'd love to hear your reasoning. Joint issuance (Options 1 and 2) would likely bring about some type of convergence between the high yielding and the lower yielding countries. Whether that convergence point would be closer to the high or the low would depend on many factors, such as: 1) the credit ratings of the lower yielding countries, which could very well decrease under a joint guarantee scenario; 2) the credibility and authority of any centralized institution established to coordinate debt issuance among the member states; and, 3) the existing economic conditions within the Eurozone, which is now entering, or already in, a recession. I am not going to pretend to be able or qualified to give you a prediction in this regard. The green paper itself gives some discussion about this on pages 5 to 7. Nils Pratley's blog also has an interesting post in this regard, with a much less optimistic prediction.

As I said at the start of the post, the barrier dividing the inconceivable from the inevitable is crumbling. Do we tip to the Utopian side of a jointly guaranteed debt union with the abdication of national fiscal authority to a central European institution, or do we go the other way into a chaotic break-up of the European Monetary Union?

About the title of this post: I saw Rik had used this phrase over on FTAlphaville, and knew it would be the title of my next post.

PLEASE: Do not comment about my father. I posted that info to let you know why I had been silent for so long, and perhaps to illicit a few prayers. I would really rather not respond to a bunch of comments about my dad, however well meaning they may be. Thanks for your understanding.

Pattern Failure

2011-11-17T23:40:00.001-05:00

Today we had a failure of the symmetrical triangle pattern in the RUT, and other indices as well. Here is a link to TradeChartPatterns.com that explains the implications of such a failure.

In the RUT, the failed pattern targets 660.94, and would be most consistent with the green count. The magenta count, which says we are still in a second Minor X of (2) could have bottomed at today's close, or could target the support around 694. [c] = [a] of X at 690.72.

RUT 10

If the green pattern is playing out, the action so far would look like this on a one minute chart. Seems to me that all of the second waves have been somewhat overly strong, but remain technically valid.

RUT 1

The latest attempt to have the ECB do what politicians refuse to do involves a scheme to allow the IMF backstop EMU sovereigns, borrowing from the ECB to do so. The details can be found at Reuters. A few things come to mind immediately:

1. Bonds supported by the IMF would be super-senior, potentially setting up a two tier market.

2. Exposing the IMF so heavily to Europe may not fly in China, where the population does not understand why it needs to pay to bailout rich Europeans.

3. Has the potential to become a political issue regarding government spending and bailouts of foreign governments in the US.

4. Probably still objectionable to the Bundesbank, as it is merely a backdoor way of having the ECB fund sovereign deficits.

EUR/USD Fib Confluence Resistance Levels

2011-11-16T22:59:00.001-05:00

EUR/USD appears to have made some type of short term bottom. I don't count currency pairs with EW anymore, but the 10 min chart below shows a possible EW type pattern implying an unfolding correction.

10 MIN

If the pattern is correct, it is supportive of the end of the triangle for Minor X in equities. That means we should look at possible resistance levels for a bearish reversal. The heavy red lines on the 8 hour chart show triple fib confluence resistance levels where we might expect that reversal to occur.

8 HOUR

An excellent article in Der Spiegel regarding the role of the Bundesbank within the ECB, the debate over the ECB as sovereign LOLR, and the support for Jens Weidemann's position inside Germany:

Germany's Central Bank against the World

Tentatively....

2011-11-16T18:10:00.001-05:00

One of those nights where I am hesitant to post a potentially misleading count, but I still think we are just about done with a triangle Minor X. The charts list the levels where these counts fail. You just knew the market would present us with this choice in an overnight session, where stops can be meaningless unless you play futures or currencies to hedge.

DAX 10

RUT 10 MIN

Hard truths about the euro from Mervyn King

"This phrase 'lender of last resort' has been bandied around by people who, it seems to me, have no idea what lender of last resort actually means, to be perfectly honest. It is very clear from its origin that lender of last resort by a central bank is intended to be lending to individual banking institutions and to institutions that are clearly regarded as solvent. And it is done against good collateral, and at a penalty rate. That's what lender of last resort means.
That is a million miles away from the ECB buying sovereign debt of national countries, which is used and seen as a mechanism for financing the current-account deficit of those countries, which inevitably, if things go wrong, will create liabilities for the surplus countries. In other words, it would be a mechanism of transfers from the surplus to the deficit countries. That's why the European Central Bank feels, and with total justification, that it is not the job of a central bank to do something which a government could perfectly well do itself but doesn't particularly want to admit to doing.
I think it's very important to recognise that there are circumstances where governments will try and put pressure on central banks to do things that they would like central banks to do in order to avoid their having to own up to the actions that they actually would like someone else to carry out. So I have every sympathy with the European Central Bank in this predicament ...
The only circumstance in which looking at the data for the euro area as a whole has merit is in realising that actually the euro area does have the resources, if you were to regard it as a single country, to make appropriate transfers within itself. It doesn't actually need transfers from the rest of the world. But the whole issue is, do they wish to make transfers within the euro area or not? That is not something that a central bank can decide for itself. It is something that only the governments of the euro area can come to a conclusion on. And that is the big challenge that they face."

The Danger of the ECB as LOLR

2011-11-15T18:50:00.001-05:00

This is just a brief follow-up to my earlier post in which I highlighted the danger that an expanded role for the ECB in this crisis would make it the de facto central government of the EMU. I found two stories on Reuters that not only add credence to my argument, but should give rise to great misgivings about the wisdom of an ECB engaged in fiscal policy.

ECB debates ending Italy bond buys if reforms don't come This article is from November 5, and speculates about what the ECB might do if Italy does not comply with their demands.

European Central Bank lowered bond purchases to $6.2 bln last week despite turmoil in Italy This article from the WP tells us the details of the lowered bond purchases in the week that led up to Berlusconi's resignation.

Was it the ECB, in the bond room, with the dagger? This is an opinion blurb on Reuters that has to make you wonder... I am re-posting it here in its very brief entirety:

It turns out that it may have been the European Central Bank that finally finished Silvio Berlusconi off.
The central bank revealed on Monday that it severely reined in its government bond purchases last week, just at the crucial moment as markets were pushing Italy’s borrowing costs beyond the 6 percent pain threshold that finally forced Silvio to jump.
The ECB’s bond purchases have long been its torture method of choice. It turns them off when it wants more from its victims and opens taps when it gets what it wants.
This time it looks like it was Berlusconi’s head they were after. Maybe its not surprising his final outburst was a parting shot at the ECB calling for it to show some mercy and act as the lend of last resort for the euro zone.

This is getting downright Orwellian!

Finishing the Triangle?

2011-11-15T17:05:00.001-05:00

Not much time to expound on things tonight, but my count has us due for a whoosh down to complete a Minor X triangle tomorrow. A sharp rebound in Z should follow. The 10 minute DAX and RUT charts give some key levels to watch.

DAX 10 MIN

RUT DAILY

RUT 60 MIN

RUT 10 MIN

TNX 10

EUR/USD 8 HR

Support around 1.344x?

Meat Grinder

2011-11-14T21:27:00.001-05:00

The market today was excruciating. I looks to me as though we are still in a triangle. Given the way it is taking its sweet time, I am promoting its degree to that of a Minor wave. Whether we are done with [d] of the triangle is an open question.

RUT 30 MIN

RUT 60 MIN

DAX 10 MIN

DAX 60 MIN

TNX still looks like it wants to advance to higher yields, which would be consistent with a sharp thrust out of this Minor X triangle in equities.

TNX 10 MIN

Mr. Binve had an interesting chart up concerning the BPSPX, which I am copying here. He uses it to support the idea that the rally off of the March 2009 lows has yet to complete. You can read his reasoning here.

BINVE'S BPSPX

I respect Mr. Binve's thinking, so a chart like that gives me pause. However, what he calls Primary [B] of Cycle w, I call Primary [5] of Cycle V of Supercycle (III). The peak BPSPX reading in the middle of his [B] wave is where I put my Intermediate (3) of [5], which is where it would be expected to be in an impulse wave. Furthermore, I would expect a Primary [B] wave to end on a high BPSPX note, which his [B] did not. The fact that the record May 2011 BPSPX reading occurred near the top of what I call Primary [B] of Cycle a further supports my case. (Recognize that Binve and I are irreconcilably split regarding whether the 2002 to 2007 advance was I five wave. I say it was, he says it wasn't.)

Finally, on a non-technical note, I stumbled upon this little gem of an article at EUBusiness.com.

German exporters can do without the euro: federation

Actually, I searched it out after hearing a very interesting BBC Business Daily interview with Anton Boerner, the head of the German exporters' BGA industry federation. His message is that Germany would like to keep the Euro as a currency, but not at any price. He says German taxpayers are done paying for the mistakes of others, and that what is important to German business is free trade and the European Common Market - much more so than a common currency. He cites the examples of Poland, the Czech republic, and Switzerland as countries who do very well in the common market without sharing in a common currency. Furthermore, and I found this fascinating, he raises the example of the Swiss National Bank's (SNB) recent devaluation of the Swiss Franc as an example of how an overvalued currency could be managed. Undoubtedly, this is in anticipation of what would surely be a strong Deutsche Mark if Germany left the EMU.

I can't seem to upload the interview, or link directly to it, but you can download it from http://www.bbc.co.uk/podcasts/series/bizdaily. It is the November 14th episode entitled "German Anger."

I have often thought that the endgame for the EMU could be a German exit. Obviously, a strong DM would result and would hurt German exporters. However, there would also be the need to recapitalize banks due to massive losses on sovereign debt, and this could lead to Bundesbank easing, ala the SNB. One wonders if Germany is looking for excuses to leave, despite all of the Eurocentric rhetoric out of Merkel. As Rik points out, she is a politician with an election on the way. If anger arises in Germany over the cost of a seemingly endless bailout of the PIIGS(F?).... Alternatively, if the ECB changes its stance regarding LOLR to sovereigns, going against the Bundesbank ....

Brief Count Update

2011-11-13T18:47:00.001-05:00

As the title says, this will be brief. The chart contains the narration. The green count, my least likely option, has already been violated by the DJT.

RUT 10 min

I am very curious as to what will happen with the TNX in the next few days. The US bond market was closed Friday. I am watching 22.4 for a possible reversal to lower yields.

TNX 10 MIN

The ECB - Headlong into the Rabbit Hole? (Update 1)

2011-11-12T16:13:00.001-05:00

"In another moment down went Alice after it, never once considering how in the world she was to get out again."

So, why are the markets rising in the face of widening French-to-German spreads, rising Italian bond yields, and temporary inversion in the Italian bond market (2yr yield > 10 yr yield)?

Some ascribe it to the new technocratic governments installed in Greece and Italy. I totally disagree. Taken in isolation, unelected technocracies with close ties to central EU organizations and the ECB have a better chance of inciting revolt in their countries than they do of forcing through unpopular austerity mandates dictated by Berlin, Frankfurt, or Brussels. They are simply Vichy regimes. For more on this, I recommend Debt And Democracy in The Economist, and Eurozone Turmoil: Enter the technocrats in the FT.

Few would ascribe it to progress on the issues of bank recapitalization or EFSF leveraging. In fact, I believe the market has come to the realization that the EFSF really has no chance of being meaningfully levered under current proposals. Wolf Richter at Testosterone Pit has an excellent post up regarding the pipe-dream of having China invest in the EFSF. I have discussed the financial engineering behind the EFSF many times before, dismissing it as less than confidence inspiring, to say the least.  The market seems to have ratified my opinion on Nov 7th, when an EFSF bond auction went rather poorly. For more on this (if you have time to waste), I recommend FT Alphaville at these two links:

    EFSF: a circular, counterproductive, and creative cannibal
    EFSF: a circular, counterproductive, and creative cannibal (continued)

I think no one would ascribe the market's advance to any credible program to sustainably restructure Greek debt. That is an agreement in principle only, and has now been relegated to yesterday's news by Italian developments.

My answer is that the market is now starting to price in unlimited ECB support for sovereign debt markets. Sure, many ECB governors, Trichet, and now Draghi, have emphasized the temporary nature of the ECB’s Securities Market Program(SMP). Axel Weber and Jurgen Stark haveresigned positions in protest of SMP activities. The Bundesbank’s Jens Weidemann has beenadamant that the ECB will not monetize debt. Nevertheless, I think the prevailing attitude remains that all of theseguys are bluffing. When their bluff getscalled, they’ll drop all of the dogmatic objections and start printing the Euros. The Italian issue is calling the bluff, and a big ECB QE operation announcement is expected any day now.

The reasoning for such an unlimited QE announcement is compelling. If the ECB were to announce that it would cap yields at a certain level with an unlimited commitment to buy sovereign debt, even if that meant abandoning its sterilization activities, the following results are expected:

A stabilization of confidence in EU debt markets. Solvency concerns would be relieved.
Parliaments and voters would not need to participate in the decision. In fact, they could not, which is seen as a plus.
A restoration of sustainable yields for essentially solvent sovereigns, like Italy, Spain and France.
A reduction in the need for bank recapitalization, as asset values rise.
Little chance of inflation due to debt monetization, as the announcement of the QE commitment alone would stabilize markets without the ECB actually needing to carry out massive purchases.

The objections to such a program revolve around potential violations of the Maastricht and Lisbon treaties, German concerns about hyperinflation, moral hazard, and covert, unlegislated wealth transfer. QE advocates dismiss the German concerns using the reasoning in bullet #5 above. Treaty objections can be technically overcome as long as the bond purchases take place in the secondary, and not the primary, market. That the spirit of the treaty restrictions - a prohibition against debt monetization of individual sovereigns - would be completely violated would be the subject of academic wrangling and little else, although the German Constitutional Court could have something to say about this issue. I have mentioned the idea that Draghi, an Italian, would be hard pressed to undertake this action in support of Italy so soon after assuming his ECB Presidency. However, with France now coming into the spotlight, he would have the full support of Sarkozy and Germany could easily find itself very isolated on the issue. The issue would be framed as "Is this the 'European's Central Bank, or the German's?" Moral hazard objections posit that overly indebted countries would lose their motivaion to enact needed reforms if their borrowing costs are artificially supported. In my opinion, this objection is unimpeachable, along with the idea of unlegislated wealth transfers. I will not expound more on these last two objections in this post.

The overall concept would be for the ECB to morph into a FED-like role. It would become the lender of last resort to sovereigns in Europe. The Treaties establishing the ECB do NOT grant it this role with respect to sovereigns, but neither do they explicitly deny it. So, let's assume that market and political pressure lead the ECB to adopt the lender of last resort role.

To begin with, if the ECB is going to take on a role like the FED's, it is worthwhile to compare the two institutions and the environments in which they operate.

The FED operates in a system with a federal republic and a central treasury and a single currency. The ECB operates in a monetary union with a single currency that is composed of individual sovereign nations and has no central treasury.
The central government in the US has the legislative authority to tax and to apportion funds. There is no such corresponding authority above the individual sovereigns within Europe.
The Fed loans to the US Treasury unconditionally. By "unconditionally," I mean that it is the Treasury that decides how to apportion and account for the funds, not the Fed.
The Fed operates in a system which issues bonds at its own level - the national level. There are no such equivalent bonds in Europe at the supranational level of the ECB.

Obviously, these are critically important differences. When the Fed was established, institutions were firmly in place to arbitrate fiscal policy at the national level. National bonds were in place so that the Fed supports the sovereign on its own level, as opposed to from a level above it. The immense danger in having the ECB take on the role of the Fed derives from the fact that none of these institutions or instruments exist in Europe at the ECB's level. Hence, the ECB would not operate at the level of the countries it lends to, it would operate from a higher level, a supranational level. While the Fed's role as lender of last resort may be purely that, the ECB would have a critical vacuum to fill in a similar role. It would the ECB's decision as to who it lent to and, most critically, under what conditions. In the absence of a central fiscal authority at the European level, the ECB would be the institution to dictate conditions for receiving its funds. Those conditions could include debt/GDP targets, deficit reduction targets, enforced austerity measures, labor market measures, etc. In fact, such demands have already been made, the latest occasion being a letter from Trichet to Italy in late September demanding certain actions. Given the lack of a supranational Eurobond, the ECB would also have the power to decide whose bonds it would purchase and whose it would sell. In short, the ECB would become the central government of Europe, and an unelected and opaque one at that.

The take away point: The Fed is a monetary authority, while the ECB would be both a fiscal and a monetary one. While the Fed may be the USA's lender of last resort, the ECB would be Europe's paymaster/treasurer.

Whether the elected leaders of European nations will allow their citizenry to be subjugated to such a powerful unelected bureaucracy, and whether the citizens will stand for it, remains to be seen....

"Give me control of a nation's money and I care not who makes it's laws"
-Mayer Amschel Bauer Rothschild

"Whoever controls the volume of money in any country is absolute master of all industry and commerce."
-James A. Garfield, President of the United States

For Further Reading: (NOTE: I offer these solely as a way for you to widen your horizons on this matter. I do NOT necessarily agree with the opinions expressed in these articles, and, in some cases, I vehemently disagree!)

ECB Stark: ECB Can Never Become Lender of Last Resort

Slovak PM says ECB shouldn't buy govt bonds

Germany won’t budge on ‘lender of last resort’

ECB Should Buy More Government Bonds, Spanish Bank Group Says

ECB as Lender of Last Resort Would End Crisis for Silva

Permanent EU Bailout Fund Said to Face Delay on Bond Loss Clash

Mario Monti: Italians divided over man touted as next prime minister – video

Can Europe pull back from the brink?

The emergence of the Frankfurt Group has turned back the democratic clock

Eurozone debt crisis: EU members line up to demand ECB intervention

Eurozone turmoil: Enter the technocrats

It’s time for you to fire the silver bullet, Mr Draghi

Does the ECB really have a silver bullet?

Why the ECB saving the euro is anything but simple

Euro Zone Considers Solution of Last Resort

Demonstrators return to protest against financial markets

Pulling for the home team

Europe’s Darkness at Noon

Bini Smaghi’s Resignation From ECB Opens Board Seat for France (Should have been titled "Fox Spotted Entering Henhouse")

EDIT: One of the internet sources I truly value is FT Alphaville's blog. It can be pretty technical, and may fly over your head at first. To that, I would say - get taller! In any case, we have the distinct honor of having Rik, one of FT Alphaville's most valuable and respected participants, posting a comment on this blog! I very much recommend you read his contribution.

DAX Close

2011-11-11T13:17:00.001-05:00

The idea of a subdividing [iii] of 1 of (3) is off the table. My three alternatives at this point are:

1. A Minor X concluded yesterday, and we are now in Z of (2).

2. We finished [d] of a triangular X of (2) that will conclude early next week, leading to a thrusting Z up.

3. We are painting a leading diagonal [i] of 1 of (3). When it concludes, we would also see a sharp rally.

DAX 60 MIN

My Other DAX Count

2011-11-10T23:25:00.001-05:00

From my last post, my count would have the DAX begin to crash in earnest tomorrow. Hence, this is one of those times to concentrate on a possible alternative so one is not left like a deer in the headlights if the market surprises. Given the depth of conviction that the ECB will do whatever is necessary, if necessary, I think we do have to consider the alternative here.

My alt is shown in green. It would mean that (2) is unfolding as a triple three, with us now in a triangular X wave, about to enter a thrusting Z wave up to finish (2).

DAX 60

Gavyn Davies has a great article on this issue of ECB monetization up at the FT. I highly recommend you read it. I put my own two cents worth forward in the comments section, rather sarcastically. My comment is reprinted for you below.

Apparently, the world is on the verge of entering a blissful state of Utopia (from the Greek for "no place") driven by the monetization of debt. Debtors rejoice - all is forgiven! Creditors relax - you will be paid with newly printed fiat "money ." Those of you who have worked hard, innovated, produced and saved for your futures and childrens' futures, we thank you. It is through your generosity that your rather less motivated and productive, yet newly christened brethren are delivered.

Centuries of inequality, nationalistic strife, and hardship are simply disappeared by the decision of an omnipotent, unelected Italian bureaucrat! It's a miracle.

Just one question about the economic model for this new age:

Shall we call it 'COMMUNIST CAPITALISM," or "CAPITALIST COMMUNISM?"

DAX Close and More

2011-11-10T13:22:00.000-05:00

DAX 10 MIN

EUR/USD

Watch 1.37

The French/German 10y spread continues to widen.....

UPDATE 3-ECB policymakers reject bigger crisis role for bank (Reuters)

Amended Count

2011-11-10T08:48:00.002-05:00

Based on the level of retrace in the DAX, and futures activity, I am posting this update to my counts for RUT and DAX.

RUT 1 MIN

742 looks important if this count is correct.

DAX 10

We are right now at the .618 retrace of what I am calling i. Watch carefully!

Shiva - is that you?

2011-11-09T19:13:00.000-05:00

My tentative hunch from last night may be coming to fruition. I based it on the patterns I was seeing, but also on the fact that LCH Clearnet has fairly consistently raised collateral requirements on holders of sovereign debt as yields approached 7%. Obviously, this tends to accelerate selling as these thresholds are crossed, and has Italy crossed it.

Something else to pay very close attention to in European sovereign debt are the widening spreads between German Bunds and French OATs. Bloomberg graphs are not updated with today's prices yet, but just look at the action in yields on these instruments today - a decidedly risk-off day.

My count for the RUT now favors us being in 1 of (3), although the blue count could get some action as blue (c) = blue (a) right around the 50 DMA.

RUT DAILY

RUT 10 MIN

RUT 1 MIN

The DAX paused today at significant lateral resistance, but I do NOT expect that to hold tomorrow. The next support level looks to be around 5600, where we may see i of (iii) of [iii] end.

DAX DAILY

DAX 10 MIN

Throwing in a SPX chart. Looks like 1242.x could be significant for a possible ii of (iii) top.

SPX 1 MIN

Potentially....

2011-11-08T23:58:00.003-05:00

I don't know how much credence to give this, but I can put together some reasonable looking counts that suggest a resumption of the larger degree downtrend very soon. I'll show you those counts without much narration, and then present some alternatives with the RUT at the end.

DJT WEEKLY

DJT DAILY

(Note test of 200 DMA)

DJT 60 MIN

DJT 10 MIN

(Note ED for (c) of [ii]. The alternative to an ED that has not been confirmed by a downturn is a subdividing third wave, so be careful!)

FTSE MONTHLY

FTSE WEEKLY

(Tested 50 wk SMA)

FTSE DAILY

(Note test of 200 DMA)

FTSE 60 MIN

FTSE 10 MIN

DAX WEEKLY

DAX DAILY

(Note failure at lateral resistance)

DAX 60 MIN

DAX 10 MIN

DJI 10 MIN

RUT DAILY

RUT 10 MIN

(Here is where I show the alternatives in red, green, and blue. See last night's count for details)

What gives me pause about these counts are:

1. The very shallow retrace in TNX, mentioned last night. Perhaps it's just that bond traders are less easily fooled (at least for now...)

TNX 10 MIN

2. The lack of confirmation in EUR/USD. As I mentioned last night, I am expecting some modestly higher levels before we see a reversal.

It continues to amaze me that markets believe that getting rid of scapegoat politicians in Greece and Italy in order to install politically insensitive technocrats to do the bidding of the EU is going to end well.

It also strikes me how differently credit and sovereign debt markets are behaving from equities. I wonder how that's going to work out...

CDS PRICING

FRENCH 10 Y VS GERMAN 10 Y

(5 YEARS)

FRENCH 10 Y VS GERMAN 10 Y

(6 MONTHS)

Divergent paths!

ITALIAN 10 YR YIELD

(7% may be a critical level, if the experience of the "three little piigs" holds true.)

One last thing. Archie wanted a count for the USD. I really don't like to count fiat currencies, as there are too many non-socioeconomic interferences with their value. I feel currency EW is like using a micrometer to measure a football field - wrong tool for the job. Nonetheless, EW does offer a rough way of projecting one's opinion, so mine is given in the chart shown below.

USD WEEKLY

I just gotta believe that, once the world gets a chance, it will look desparately for alternatives to the USD as the world's reserve currency, and to the dismal returns on US government debt.

Waiting For Shiva - Stuck With Vishnu

2011-11-08T00:12:00.001-05:00

Well, I'm back, and not too thrilled about it. I return to find markets clinging to the idea that punishing a few scapegoats, like Papandreau and Berlusconi, will serve some purpose. These developments are merely an irritating distraction. The ultimate truth is that Germany has not got the will or political environment to support the EMU to the extent that would be required. Furthermore, the ECB is unwilling to print unlimited Euros to sustain the myth that countries like low-growth debtors like Italy deserve to be able to issue debt with yields close to those of high-growth, competitive nations like Germany. But, we don't seem to be at that point of recognition yet.

I'll use the RUT to illustrate my three main counts. The red sees [ii] of 1 of (3) as nearly over, and would require a big drop asap. The green sees us in [z] of a triple-three Y of (2). The blue puts us in a larger [x] of Y, and would be a bear trap, as it would imply a (c) wave down that could look like the start of [iii] of 1 of (3).

RUT 10 MIN

I tend to favor the two counts that have us still in (2), largely based on the sideways trading of the Euro and the still smallish correction of the recent decline in the TNX.

EUR/USD 1 HOUR

EUR/USD 8 HOUR

TNX 10 MIN

TNX 60 MIN

My bear radar is set to alert loudly if TNX reaches 22.35, and/or EUR/USD reaches the 1.3927 to 1.400x range.

DAX Close, Links

2011-10-28T11:53:00.000-04:00

Probably some more modest upside early next week.

DAX 60

DAX 10

Italy Pays Higher Yields at Debt Sale (OK, so if I can't hedge my portfolio with CDS, then I'll either liquidate it or demand a higher risk premium to hold it!)

Fitch: Greek Debt Deal a Default (Yeah, but not enough of one....)

Swiss Cheese

2011-10-28T00:07:00.002-04:00

I have decided not to write up a detailed review of the Euro summit results, as there is really nothing concrete to write about. They basically took everything the market wanted to hear and said that's what will do. All that is missing are the details. I could burn up a good deal of my time and energy going on about why some of those details are so crucial, but there is already a plethora of excellent commentary out there in just one day.

Instead I want to point out that some crucial targets have been hit by Intermediate (2) at this point. If we are going to turn into a (3) wave, this is as good a point as any. Most obviously, the psychology has changed to one of much greater bullishness. In fact, it has changed so much so that I feel somewhat foolish even posting these counts. BPSPX is well into bullish sentiment territory, as is the AAII survey.

AAII

More importantly, the EUR/USD has hit and reversed (for now, anyway) at a very strong looking fib confluence and lateral resistance level.

EUR/USD 8 HR

EUR/USD 15 MIN

TNX appears to have completed a five wave move up from its all time lows, which I interpret as the top of a [c] wave of 4.

TNX 60

TNX 10

The DJT, which sports one of the cleanest five waves down of all indices from its July all-time peak, has now retraced .618 of that decline. It has also challenged its 200 DMA.

DJT WEEKLY

DJT DAILY

DJT 60

The DJI has a reasonable looking count to show a complete rally. The SPX does not have the same structure, but may conform more to the red 30 min RUT count I'll show below.

DJI 10

The RUT has closed an important gap and has fulfilled the criteria for an expanded flat (2). The green count would imply that there is some more to go in C. However, the red 30 minute count shows a very viable double three. (The red count does raise the question of whether an x wave can extend beyond the origin of the pattern, but I can find no rule saying it cannot.)

RUT 60

RUT 10 GREEN

RUT 30 RED

On the other hand, besides these key levels in the EUR/USD and TNX, I am watching NYSI. Rally failures at a level below 500 have some significance as a reversal indicator, although I am not overly impressd.

NYSI

I am also closely watching a developing bulling engulfing candle on the monthly SPX chart. It is evidently the largest monthly rise since 1974. The bearish case would seem to require that this rally reverse soon enough to cut that candle down to size.

SPX MONTHLY

However, what may really be the nail in the coffin for this rally is that Blankfiend will be on vacation for a week, starting Saturday!

Good luck all!

Beware the NPV

2011-10-27T10:00:00.002-04:00

So, we have a plan. Just a few minor details to fill in now. Riiight!

I am particularly curious about the 50% write-down in theprivately held notional value of Greek debt. The IIF statement reads:

"The specific terms and conditions of the voluntary PSI will be agreed by all
relevant parties in the coming period and implemented with immediacy and
force. The structure of the new Greek claims will need to be based on terms
and conditions that ensure an NPV loss for investors fully consistent with a
voluntary agreement."

So what does this really mean for Greece? The real key here is the forward discount rate on the bonds. If you write down the face value of a bond by 50%, but then increase the discount rate (interest rate) from 9% to 20% over the remaining maturity, you:
1. Maintain the NPV (net present value) of the bond, which prevents a write down on bank ledgers.
2. Do nothing for the debtor in the longer run.

I have many other questions, and will dive in some more later, but here is my sense of levels to watch.

TNX 10 MIN

DAX 60 MIN

RUT 10 MIN

EUR/USD

DJT 10 MIN

Europe - No Way Out

2011-10-26T15:12:00.001-04:00

As the world awaits some miracle to emerge from the latest EU crisis summit tonight, I want to review some issues.

1. Greek haircuts. The latest is a push to have banks "volunatarily" write down Greek bonds by 50% of face value. The voluntary part is to avoid triggering CDS and having a credit event. ~~(see footnote)~~

a 50% haircut is insufficient. For Greece to have a prayer, it would need to be upwards of 70%. 50% would actually be a premium to the way this debt is priced today.
Banks are unlikely to "voluntarily" do such a write-down. Even if they did, credit rating agencies are unlikely to score a write-down of this magnitude as voluntary.
Banks that are hedged via CDS against their Greek holdings are motivated to seek a Greek default so that they can (theoretically) recover losses via their hedges, assuming counterparties will be able to pay. If these same banks are forced to write-down voluntarily and have to suffer a 50% loss on their Greek debt without being able to exercise their hedges, the precedent is set that hedges against potential losses on other sovereign debt are likely worthless. This would lead to liquidation of that other sovereign debt and major escalation of contagion.
Unless Greece gets a meaningful degree of debt forgiveness, it is going to default - hard. Ask yourself why it wouldn't.

2. Bank Recapitalizations: The idea is to force banks to attain a 9% Tier 1 capital ratio without selling assets. The figure in circulation is 108 billion euros. Theoretically, banks would do this through an equity raise. Failing this, they would go to their parent governments next, and the EFSF as a last resort.

There is no reason to believe that banks would be able to successfully raise equity on favorable terms in this environment.
Many of the parent governments of these banks, particularly France, are unable to extend funds or guarantees without putting their own sovereign ratings at great risk.
The EFSF has about 300 billion euros left uncommited. Every additional drawdown to recapitalize banks diminishes the amount that could be levered to support sovereign debt issuance.
Most EFSF money is German money, and the German taxpayer will not be amused to see his money going to recapitalize some French bank. Nationalism still reigns in Europe and, IMHO, is making a comeback.
The 108 billion euro figure is grossly low to begin with.

3. Levering the EFSF. The idea is to somehow lever the remaining 300 billion euros in such a way as to provide some type of first loss layer for new bond issuance by distressed sovereigns, particularly Spain and Italy. I have covered much of this before, most lately in this post. The latest iteration of this idea is for the IMF to establish a Special Purpose Investment Vehicle (SPIV) that would combine EFSF resources, its own resources, and contributions from sovereign wealth funds and other investors. The EFSF capital would be the first loss layer in this structure.

The EFSF has no capital - it is all in the form of guarantees. In other words, the first loss layer of this SPIV would be money that the Germany, France, Italy, Spain and others "promise" to pay if the crisis escalates. "Just call us if we need to pay you. We promise we will. No, really, we DO!" Nobody is going to put any confidence in this type of funding for a first loss layer.
IMF funds are super senior debt. They will not serve as a second loss layer, or any loss layer.
That leaves the contributions of investors to essentially take all of the losses incurred, unless of course the EFSF really were to pay up in event of disaster. Even if it did, losses would likely far exceed the advertized 20% "protection."

4. The Role of the ECB. The Germans have insisted that the ECB NOT be a participant in any scheme to lever the EFSF, and are highly resistance to ECB bond buying via its SMP (securities market program). Germany appears to have gotten its wishes in this regard, as the ECB has insisted that it will NOT help lever the EFSF, nor will it support the EFSF in obtaining a banking license. This stance is very unlikely to change, at least in the near to medium term.

Mario Draghi, the incoming ECB president, is Italian, and was endorsed for the job by the Bundesbank based on his reassurances that the ECB would not be used to monetize sovereign debt. An about face now, especially with considering his nationality, would not be acceptable to Germany.
When the Eurozone was established, Germany ardently insisted that debt monetization via the central bank not be allowed to occur. As you well know, it will primarily be the Germans who will get the capital call to recapitalize the ECB in such a scenario, essentially establishing a transfer union without democratic process. Is the Eurozone experiment now so important that the democratic wishes of Germans and others should now be overridden by an unelected bureaucrat from Italy?

5. The Euro. When I think of the role of a currency, I think of three functions:

A unit of accounting
A medium of exchange
A store of value

One of the core concepts in the establishment of the Euro as a currency was of German origin. That concept was of a currency as a stable store of value, #3 in the list above. That concept has been the mandate of ECB operations, and is a key element in the German image of the Euro to this day.
In this sense, the Euro truly is a currency. This is in sharp contrast to the US dollar or the British pound, which are only two/thirds currencies, in that they are NOT stable stores of value. Rather, the dollar and the pound are funding vehicles for structural deficits. Hence, in real terms, US and British debt is a guaranteed loss. Only through this magic of ongoing, continuous, and insidious default do the US and Britain not default on their debts in the classic sense. That the world continues to tolerate this simply astounds me, but I digress...

EDIT: Apparently now Europe is looking for a 30% "voluntary" haircut on Greek debt. While the banks may agree to this, and can pretend to not need as much recapitalization of loss on HTM Greek debt, this will drive Greece to default - soon!

Still Flat

2011-10-25T21:18:00.000-04:00

I am torn between two potential counts, as shown. I still carry the pain of my call from late July for further upside, just as we were rolling over, so I don't want to insist either way (not that it would make a difference in what would happen anyway...) So, personally, I remain on the sidelines.

The red count would gain credence should we go below 1197.34, and some fib relationships in the SPX and the DJI would certainly suggest that Intermediate (2) may have run its course. However, the RUT has yet to trade above its A wave highs, and some EU indices are not showing any signs of impulsive decline, although that could change tomorrow. Furthermore, the retrace of (1) in the DAX, DJT and RUT seems uncharacteristically weak. Hence, the blue count remains viable. If we do call this recent three day rally (i) of [v], per the blue count, I do notice a three wave look to (i) that could mean [v] would be an ED. That would be a gift from God, should it occur.

SPX 1 MIN

IMF considering participation in EU bailout fund (Reuters)

Brief Update (Updated)

2011-10-24T17:06:00.001-04:00

This is my sense of where we are. I am flat now, possibly early, but at a very nice profit. We have reached the point where I will NOT hold overnight. Yes, I do think Europe has some room to run yet in the CAC and the DAX, but I am not one bit confident that I would be able to get out during US trading hours.

DJT 10 MIN

RUT 1 MIN

SPX 1 MIN

DJI DAILY

DJI 10 MIN

UPDATE: Just wanted to add a chart showing what I consider to be key EUR/USD levels.

EUR/USD

Mixed Signals

2011-10-23T15:34:00.003-04:00

In some indices, I see us quite far away from the levels I would have expected this Intermediate (2) retrace to attain, while, in others, I find us dangerously close. That could mean:

1. The underperforming indices are about to outperform temporarily to play catch-up.
2. The underperforming indices are going to have a rather shallow (2).
3. My count is wrong.

I will start with the indices that seem to be close to reasonable targets for (2).
Firstly, the DJI. We are very close to the .618 retrace of (1) AND the 200 DMA, both in the upper 11900's. Furthermore, my count has us in a five wave C, and placing [iv] at .618 of C gets us just about to the 119xx level as well. Looking back, (2) of Primary [A] did poke above the 200 DMA twice before rolling over into (3) in 2008.

DJI DAILY

DJI 10 MIN

The SPX is in a similar spot, although seems to have more running room vs the DJI. Here, the 200 DMA is somewhat further away, although the .618 retrace is closer. The .618 retrace is obviously somewhat subjective, and mine is certainly different than most. I've been through why I have an orthodox top in July, and my 60 min chart gives an abbreviated version of that reasoning. For fib purposes, I am placing the bottom of my retrace at the deepest point achieved by 3 of (1) rather than the truncated bottom of (1) itself, or the absolute low, which I consider to be the bottom of Minor B of an expanded flat (2).

SPX DAILY

SPX 60 MIN

(Note here how the SPX has been rising with each thrust, while the RUT can't seem to. The RUT is one of my underperforming indices.)

SPX 10 MIN

SPX 1 MIN

This chart should put to bed the idea that [v] of C could be evolving as an ED.

Another relative outperformer is the FTSE. I see a resistance band in the 5600-5700 range. A longer term chart is shown for perspective, and additional chart notes justify target levels.

FTSE MONTHLY

FTSE DAILY

FTSE 60 MIN

FTSE 10 MIN

The DJT is sort of in between. Monday will be very interesting to see how the current wave up develops. Its C wave has exceeded its Minor A wave, meeting the criteria for an expanded flat. However, it does not appear to be painting an ED for [v] of C, so I am interested to see what follow-through Friday's action gets here. As per the 10 minute chart, there is a valid target around 4915, which would be the .50 retrace of Intermediate (1). However, there is also a gap target around 5000 that may prove irresistable, and could drive a push up to the .618 retrace near 5083, or higher to where C = 2.618 * A at 5212. The 200 DMA is currently at 5029.

DJT WEEKLY

DJT 60 MIN

DJT 10 MIN

The DAX is shown with two potential counts. My preferred is the black. I see major lateral resistance in the 638x range, but I see no uncovered gap targets in the DAX until we get all of the way up to 6934. I would NOT expect to see us get close to that level if my count is correct. My target range extends from 6350 to the .618 retrace at 6546.

DAX WEEKLY

DAX DAILY

DAX 60 MIN

DAX 10 MIN

The RUT is where things get interesting. This index has truly been underperforming of late. If the mood turns more bullish, I would expect it to outperform and make up some lost ground. The RUT (and the MID) are also two of the only indices with a potentially valid ED down to the early October lows. However, I do not believe that those Minor 5 of (1) lows were formed by an ED because I do not accept that the first wave of (1) was a leading diagonal.

RUT TOP OF [B]

That would make the count shown below INVALID.

RUT WRONG COUNT

I feel pretty good about what the right count actually is here, but am really looking forward to Monday to get a sense of what follow-through Friday's bullish action gets. I think the RUT will break out of its trading range here, and I do expect it to surpass its Minor A peak near 737 before (2) is over. However, I am completely unsure as to whether it will just squeak above 737, or blow past it. What particularly disturbs me for the RUT is the fact that putting [iv] of C at .618 only brings C up to 728 or so, which would not meet the criteria for an expanded flat (2). This makes me wonder if [v] of C might not extend, which potentially could take us all of the way up to 806. That would be well past the 200 DMA, so I consider it unlikely. In any case, I am left with a very wide (synonym = worthless) target range for the RUT. I will endeavor to refine that range as we go along.

RUT WEEKLY

RUT DAILY

RUT 60 MIN

RUT 10 MIN

MID is shown here just to bolster my long-term counts, and will not be discussed further.

MID WEEKLY

MID DAILY

Finally, I want to look at TNX and the EUR-USD. For TNX, I see us approaching the top of a Minor 4 of the final impulse wave down for a loooong time to come. A potential target for the top of 4 is around 23.8, although I am not sure we get quite that high.

TNX MONTHLY

TNX 60 MIN

TNX 10 MIN

As to the EUR-USD, I have sworn off trying to put EW counts on currency pairs. However, I do see two potential reversal ranges for the current Euro rally. This first is around 1.403 or so, and is a loose confluence of fib resistances. The second, and perhaps more likely, is at 1.425. and is a very tight confluence and lateral resistance zone.

EUR-USD 8 HOUR

EUR-USD 4 HOUR

The weekly EUR-USD chart shows a trend of lower highs and lower lows, with choppy looking advances, and impulsive looking declines.

EUR-USD WEEKLY

And, from Zero Hedge, I grabbed the chart below, which shows the type of strong short interest in the EUR that could lead us to a quick advance toward that 1.425 range.

EURO SHORT INTEREST

A final scatalogical remark, regarding the dog and pony show to rescue the Euro. The market rallied on Friday because someone suggested that the European Stability Mechanism (ESM) could be brought forward and combined with the European Financial Stability Fund (EFSF). As you (should) know, the EFSF is the temporary measure with 440 billion of lending capacity and funding via callable capital guarantees. The ESM is the permanent mechanism that was to replace the EFSF in 2013, and would have 500 billion of lending capacity funded by paid-in capital. It is quite clear from the ESM Treaty that the ESM was never supposed to be additive to the EFSF, as you can read below:

TRANSITIONAL ARRANGEMENTS

ARTICLE 34

Relation with EFSF lending

During the transitional phase spanning the period from June 2013 until the complete run-down of

the EFSF, the consolidated ESM and EFSF lending shall not exceed EUR 500 000 million, without prejudice to the regular review of the adequacy of the maximum lending volume in accordance with Article 10. The Board of Directors shall adopt detailed guidelines on the calculation of the forward commitment capacity to ensure that the consolidated lending ceiling is not breached.

__________________________________________________________________________________

Changing this restriction to make the two programs additive would:

1. Require approval in all 17 Parliaments again (ain't happening)

2. Nearly double the budgetary bailout commitments of Eurozone sovereigns, to include Italy, Portugal/Ireland (which do not pay into the EFSF, but are slated to contribute to the ESM), and FRANCE!

3. If combined with a 50+% haircut on Greek debt and a substantive government funded bank recapitalization, could be enough to cost France its AAA.

I am preparing to be overwhelmingly underwhelmed by the results of this extended Euro summit.

Euribor-OIS

Dramatic rise in last one year.

Euribor-OIS

Still nowhere near 2008 levels.

GERMAN-FRENCH 10 YEAR SPREADS

Highest in 5 years

IMPORTANT VIDEO WITH LARRY FINK OF BLACKROCK: http://video.ft.com/v/1231242136001

An Good Panel Discussion From Deutsche Welle

2011-10-22T16:22:00.000-04:00

http://mediacenter.dw-world.de/english/video/#!/297925/Quadriga/Program=7296

The host looks like Richard Dawson from Hogan's Heroes...

Forget the ED Idea

2011-10-20T13:28:00.001-04:00

Obviously, today's declines wrecked the ED idea I had last night in some indices (maybe not the DJT or SPX). The DAX is still hanging in there above its [i] peak, so a possible count has us just now entering [v] of C.

DAX 10 MIN

The RUT appears to be in a similar spot.

RUT 1 MIN

A great read on the EU situation can be found at the FT. Analysis: A weekend to save the euro.

From Sarkozy's office, a Wednesday summit to finalize proposals to be discussed on Sunday:

La France et l’Allemagne sont convenues que l’ensemble des éléments de cette réponse globale et ambitieuse sera examiné de manière approfondie lors du sommet de dimanche pour pouvoir être adopté définitivement par les chefs d’Etat et de gouvernement lors d’une deuxième rencontre au plus tard mercredi.

France and Germany are determined that the elements of this global and ambitious response will be examined in the appropriate manner during Sunday's summit so that they may be definitively adopted by the heads of state during a second meeting to take place on Wednesday, at the latest. (my translation)