The eurozone meltdown that we anticipated and followed up on recently continues. Sovereign yields and spreads over German government bonds (also referred to as Bunds) are still on a frighteningly steep upward trajectory. While interbank funding in euros has eased and appears stable for the time being, interbank demand for U.S. dollars continues to intensify (often a sign of looming financial risk, as we noted yesterday). Against this backdrop, some smart market participants and pundits have referred to a short bet on the euro (selling euros today and buying them back in the future, which will be profitable if the value of the euro declines during that time) as the next 'trade of the century' after shorting mortgage and mortgage-related securities going into 2008-2009. In a similar vein, we believe that sophisticated investors and speculators might want to consider taking short positions in Bunds, based on the following rationale.
The eurozone (via the European Central Bank or ECB) has the means for adding to the stock of net financial assets, but as an institution it suffers from mainstream macroeconomists' persistent ignorance of how critical this function is to a financial economy, and remains stubbornly committed to it, not just legally through its charter, but also culturally, as its two main national influences, France and Germany, have long been hard money advocates.
In the late 1920s and early 1930s, the Bank of France (the country's central bank) led the charge toward resetting gold's nominal parity at its pre-WWI level, turning what might have been a multi-nation recession into the worldwide Great Depression (the U.S. Federal Reserve was not innocent either). In the 1960s, under the post-WWII Bretton Woods monetary system, French President Charles de Gaulle railed against U.S. budget deficits (subscription required), and France increasingly redeemed its U.S. dollars for the Treasury's gold until President Nixon finally closed the 'gold window' in 1973, bringing the Bretton Woods system to an end.
Germany's bent for monetary restraint is firmly rooted in its experience with the staggering hyperinflation of its post-WWI Weimar Republic in the early 1920s, a point emphasized recently by Jens Weidmann, president of the Bundesbank (Germany's central bank) and member of the ECB's governing council (an influential member, according to the Financial Times), in a speech in Berlin on November 8:
One of the severest forms of monetary policy being roped in for fiscal purposes is monetary financing, in colloquial terms also known as the financing of public debt via the money printing press...[The prohibition of monetary financing in the euro area] is one of the most important achievements in central banking [and] specifically for Germany, it is also a key lesson from the experience of hyperinflation after World War I.
Some degree of 'hardness' in money is fine and good, and hyperinflation is certainly one of the most severe forms of government malfeasance. But economists and bankers like Weidmann, in spite their credentials, exhibit a glaring intellectual gap relating to the concept of net financial assets under a soft currency system. Simply put, if money is going to be an inconvertible creature of the state rather than being based on the existing stock of precious metals and future additions to it, then the only way that users of that currency can, in the aggregate, accumulate precautionary savings and successfully lend or borrow money is if the government sector, as the monopoly provider of the currency, runs sufficient and (under most conditions) ongoing deficits.
Weidmann demonstrates this glaring intellectual gap, and articulates some of the astoundingly wrong inferences it leads to, in comments attributed to him in a recent Financial Times article:
Mr Weidmann highlighted the stance being taken by the Bundesbank by arguing governments, not central banks, were mainly responsible for ensuring financial stability. Mario Draghi, the ECB’s new president, has said it is not the ECB’s job to act as lender of last resort, but Mr Weidmann went further, saying such a step would breach Europe’s ban on “monetary financing” – central bank funding of governments.
“I cannot see how you can ensure the stability of a monetary union by violating its legal provisions,” Mr Weidmann argued. “I don’t see how you can build trust in a system that violates laws.”
Mr Weidmann said current Italian interest rates levels were “not such a big issue” in the short run. “What we are facing in Italy is an acute confidence crisis, and only the Italian government can resolve that crisis.”
Since May last year, the ECB has been buying eurozone government bonds – a move opposed by the Bundesbank – but sees its role as limited and aimed only at ensuring functioning markets.
Mr. Weidmann must realize that trust cannot be built in a system whose legal provisions are leading directly to its long-term destabilization. Until its legal framework and operational realities are better aligned, building trust among EMU (and by extension, European Union) nations will remain a total pipe dream.
As for Weidmann's invocation of the confidence fairy, what markets are confident in, judging by their recent behavior, is that:
- At some future date, Italy, as a country that surrendered monetary sovereignty and now struggles under a heavy burden of what is essentially external debt, similar to emerging markets nations that experienced severe fiscal and currency crises in recent decades, will not be able to roll over its government debt in the private marketplace;
- At that point, Italy's creditors will receive the same treatment that holders of Greek government debt now face, which is a 50% "voluntary" haircut without any benefit from hedging arrangements they've already purchased;
- And given the current realization of (1) and (2), the European and global financial systems are now at much greater risk of a 2008-like meltdown, as sovereign debt exposures begin to severely erode the balance sheets and capital positions of financial institutions due to (a) the writing down of assets such as holdings of eurozone government debt and (b) the marking up of liabilities, such as protection extended to counter parties on such debt (although with the "voluntary" Greek haircuts, who knows how to place a value on the latter?)
To be fair, Weidmann clearly gets point (2) above, as the following comment shows. Potential government debt buyers have seen what's happening to Greek bond holders and many of them have gone on strike, driving up yields on all EMU government debt except for Finland, Germany, and the Netherlands, whose external currency requirements are met by running trade surpluses:
[Private sector involvement] might appear an easy way out of self-inflicted problems. If this is the case, you achieve the opposite of what you wanted to achieve. You will have more contagion instead of containment of the crisis because it’s seen as a potential model for other countries.
Here's the rub though—without steady expansion of net financial assets (as opposed to just private sector and government borrowing) in the eurozone, those exports from Finland, Germany, and the Netherlands, will become unsustainable somewhere around the time that net credit expansion in the eurozone becomes unsustainable—which is where the EMU appears to stand today. Given that reality, there is simply no way that Germany can remain immune to the current fate of most eurozone governments, unless it is willing to forcefully break with the legal and cultural status quo or abandon the euro experiment altogether.
There are some economists and policymakers in the EMU who appear to get this. For example, German economic advisor Peter Bofinger asserted at a recent conference that "the ECB has to act before the financial system falls. And if they act, they should act properly and set an upper limit for sovereign yields." Setting a cap on EMU government debt yields offers a simple, credible and far more efficient way for the ECB to hold the eurozone together while it works out a framework for closer fiscal integration, and while troubled nations work on resolving their fiscal challenges, than its current modus operandi.
If the ECB did that, then selling German Bunds wouldn't be anywhere near a potential 'next trade of the century.' But as long as the views expressed by Weidmann hold sway, the potential does exist, and here's why:
- In spite of the realities outlined here, investors have flocked to German government debt at the expense of most other eurozone issuers, driving up Bund prices and pushing down their yields (see the first chart below). Up to this point, that tactic has likely served active bond managers well, if not in absolute returns then at least in relative terms (i.e., enhancing their performance against benchmark indices by overweighting securities that have performed well and underweighting those that have performed poorly).
- It's likely that speculators have put on plenty of 'pair trades' as the convergence of eurozone sovereign debt yields over the last decade started to unwind in recent years. For example, a hedge fund might sell the debt of a troubled eurozone government and use the proceeds to buy the debt of a perceived safe haven issuer such as Germany. Those certainly have been winning trades to this point.
- That both of those trades would have succeeded thus far implies—along with prevailing market yields—that they could be rather crowded at this point. In that type of situation, a good contrarian speculator will look for incipient signs of a turning point—especially when the rationale for a contrary trade is as solid as the operational realities articulated above.
While they're not in crisis territory yet, the price of credit default swaps on German government debt, which provide Bund owners with protection against German default (and also allow speculators—in all likelihood, too many speculators—to make "naked" bets against German Bunds), have spiked noticeably of late, as shown in the second chart:
(Click charts to expand)
Yield on 10-Year German Bunds
Credit Default Swap Index on German Bunds
This is an indication of rising (albeit incipient) risk aversion toward German government finances. And if we take into account the uncertainty thrust upon CDS markets by the latest Greek rescue proposal, CDS on German Bunds might even be understating current risk perception around Germany.
PLEASE NOTE: Although this trade may be of interest to sophisticated speculators and some institutional investors, it is far too sophisticated, difficult, and dangerous a trade for most individual speculators to consider, and in my professional opinion, it has no place in the portfolio of the average investor. Our firm has decided that it would be too difficult to implement in our clients' accounts for whom it would otherwise be suitable, and due to capital constraints, neither our firm nor its principals are currently planning to implement the trade (that may change without notice). We have decided to publish our view on German Bunds for informational and educational purposes only, as it's our sincere hope that it might dispel some of the prevailing confusion among economists, politicians and citizens that is needlessly pulling the eurozone into recession.
IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment. We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.