As we watch, sometimes in disbelief, the seemingly endless barrage of bad news emanating from debt markets, largely centered around the stresses to the sovereign credits of Europe, we may overlook the obvious. That is, who is going to step up and buy? And I am not referring to any ECB or other 'synthetic' intervention in the market. I mean real, honest-to-goodness 'going-away' buyers. Where are they? And when will they return in enough size and scope to 'normalize' (whatever the heck that means) the markets? Those debt markets still euphemistically referred to as the ones--'over there'. One look at the S&P 500 should instantly inform observers what is 'over there' is very much 'over here'.
This all begs another series of obvious questions: What will be the catalyst that turns the tide? And what happens if it doesn't appear soon? IMF liquidity support? Another ECB 'announcement'? An 'edict' from the EU? By the by, I just witnessed an analyst on one of the major financial networks offering guidance on the enforceability of sovereign debt, relative to the country of origin, as it all pertains to the rights of potentially jilted holders! That should calm things, now shouldn't it?
I believe we are approaching, or are already partially through, a very critical inflection point. I am not sure if even sophisticated market participants fully grasp the implications of much more of a continuation of our current reality. It is a very powerful and natural human characteristic to be in denial about certain realities. Can we continue to afford the luxury of our denial?
What is eerily discomforting about these times is the realization that frames of reference do not necessarily apply. Relationships normally associated with certain circumstances and conditions have broken down and, in some instances, have fooled us. This Debt Crisis, beginning in 2007 if we are honest about it, is unlike anything we have ever experienced at anytime in economic history. The scope, the linkages, the magnitude, the mechanisms, the risks, the challenges, the variables, the potential outcomes, are all of a nature to render most observers incapable of cogently accurate predictions. But no matter how this goes, I do believe we are in the beginnings of a trend which could, and certainly will, depending on magnitude, have a profound and possibly crippling effect on many things financial.
The failure of the so called 'Super Committee' has re-focused the spotlight on political dysfunction in the U.S. Now automatic cuts will combine with some net revenue increases and will supposedly render $1.3 trillion in net deficit reduction. Yet, S&P suggested a reduction on the order of $4 trillion should be produced to avoid future downgrades. So I guess that means we are still on 'CreditWatch', or does it? Fitch certainly seems to think so, based on their current commentary. You never quite know with S&P, the same organization which stated that any European rescue facility would be rated as the lowest participant is rated. Technically, this means that the EFSF would be rated as Greece would then be rated, since the 'haircut' proposed for Greece requires the proceeds of mandatory asset sales to be contributed to the EFSF's capital base. How will that be accomplished? How will the U.S. get to $4 billion in reductions? Perhaps by formation of a 'Super-Duper Committee'? That has to be very comforting.
In Europe, we have observed an endless series of missteps and missed deadlines, as the politicians and monetary authorities have little to show for their parade of 'solutions'. Can anyone precisely lay out the current version of the 'solution'? I didn't think so. This much is clear, the lines of credit are drying up among the financial institutions of Europe. Additionally, the IMF stepped in to offer liquidity. Nary a mention of the real issue; that of solvency for both the wayward sovereigns (and maybe those not-yet-wayward) and the teetering banks. Do not fret, however, we now see the ECB will get serious about things on Wednesday.
The insidious circumstances I am referencing are visibly leading to a general, across the board, aversion to debt of most any kind, in most any market, and for most any purpose.
Now, before some readers go off into some vitriolic rant about how the debt markets are so vast, about how there is a natural, built-in demand function called re-investment, about how times of stress engender 'flights to quality', and a host of other defensive reasons, let me very clearly state that my fear is not one of the world suddenly ending for any form of debt instrument. How about the tepid move in the U.S. Treasury market on Monday for the ten year and thirty year maturities? Trust me, the 4x+ bid-to-cover for the successful two year auction is NOT good news, although the five year did well on Tuesday. Previous down moves on the S&P of the magnitude seen Monday have resulted in bigger 'flights to quality' on the longer end of the curve.
I am reasonably aware of the factors which perpetuate debt markets. What I am afraid of is such aversions to debt being at the 'margins'. There is evidence of this phenomena, like last week's semi-failure (depending on how one defines failure) of the attempt by the EFSF to raise 5 billion Euro in the markets. That it ended up around 3.5 billion Euro and that the EFSF itself needed to buy 'hundreds of millions' just to get the offering where it ended up, at rates almost double that of its primary funding source (and AAA rated peer), Germany, should send shivers down any conscious person's spine.
Not withstanding the obvious pressures many European sovereign issuers are experiencing, is the EFSF auction's performance the first tangible sign of the beginnings of a more robust and general debt aversion? If it is, we are all in much more serious trouble than we may have imagined.
Because, what (or who) is next? Is it the 'high-grade' sovereign participants in the EFSF itself (Already happening in the case of all the non-German issuers widening to Germany itself), corporates, whether high-grade or high-yield, U.S. Muni Bonds, Bank credit facilities, a renewed mortgage-backed meltdown, other 'remote' sovereigns, China, Gilts, U.S. Treasuries, or Money Market Funds?
The point is, we should not discount for one second, the potential of a general, widespread, sustained Debt Aversion, at the margins, like the EFSF just experienced. It may have already started right here in the U.S. Lots of folks bought parts of the offering EFSF attempted, just not enough of them showed up with bonafide orders. Hence, they were short. Remember, this from the issuer they still intend to leverage to 1 trillion Euro+. No one has yet announced a cancellation of that part of the 'plan'.
If they had, I would expect the equity markets to not take it very well. This, despite that fact that everyone knows the EFSF scheme is dead on arrival.
This market is strictly reacting to news, as it comes, although less so in Tuesday's action once the IMF scheme was disseminated. I believe the S&P 500 and other parts of our equity markets are very positively biased. Reliance on decent past 'fundamentals' will disappear quickly once the evidence of Debt Aversion is undeniable. Given the political irrectitude on both side of the Atlantic, can that moment be far off?
What if enough folks do not show up for other major and minor offerings to come?
Then, obviously, we will be in much more trouble than we could have imagined. A 20%-30% decline in the S+P is very conceivable, as fundamentals deteriorate rapidly and fear and panic really set in. Let us not forget that equity is still on the bottom of the macro capital stack last time I checked, and equity is therefore levered to outcomes. Given Congressional trading prowess, as recently evidenced and reported, the 'smart money' from both side of the aisle will be out by then, won't they now?
All this without the World, as we know it, ending. Just ending 'at the margins'.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
