Market Extremes Encourage Similar Outcomes In Europe

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 |  Includes: CNY, ERO, UDN, UUP
by: Douglas Borthwick

There are a few interesting things to be aware of in the EUR/USD. Namely the EU/US 2-Year Basis Swap and the 10-Year US/Germany yield differential.

The EU/US 2-Year basis swap is at 84 bps. We last saw this on Dec 4th 2008; reaching that level resulted in a large snap-back of the basis swap to 20 bps by Jan 9, 2009. The EUR/USD rallied from 1.2550 to 1.4710 on Dec 18, 2008, finally resting at 1.3700 by Jan 9, 2009.

The 10-Year US/Germany yield spread has jumped from 27bps in the US favor to 30bps in Germany favor over the course of this week. The last time a move this swift was seen was on March 10, 2009; as the yield differential moved from flat to +70 bps in Germany's favor by March 18th, 2009. This move saw the EUR/USD rally from 1.2680 on March 10, 2009 to 1.3476 by March 18th, 2009.

Both situations need to be looked at carefully. My base-case belief is that the EU and the ECB are forcing European governments into austerity programs and banks into de-leveraging activities. The question remains... Why would they do this when it disrupts markets as much as it does? The answer is Machiavellian in nature. As the US has shown following Lehman's demise; governments only act when under times of extreme stress, and banks only de-leverage when they are forced to by the market. I believe that although there is significant uncertainty today, the chance of a significant pull back is very real.

December 9th is seen as a deciding date by European policy makers. While Germany and the ECB have so far had their way in the installation of technocratic governments, they are still holding out for significant Treaty changes. They believe they will get these as long as the market remains in a stressed condition.

I continue to believe that there are a number of plans in the works that will help alleviate the market's concerns in the near term. These are in-country and in-region. In-country I believe the EU is pushing RolandBerger type plans within Italy and Greece to identify state assets that can be ring-fenced, and used as collateral for the IMF. I believe that the 'Wise-Men' Redemption Plan is also being discussed. This plan would take all debt over 60% debt to GDP off individual countries shoulders, with each individual country's overage backed by these ring-fenced assets, which will then be sold off over time in order to retire the debt. Much of this overage will be transferred from the ECB's balance sheet to an IMF-managed vehicle that will seek to refinance the debt at lower levels than that seen in the current market. As we are all aware, the IMF always gets paid back 100%. I believe the ECB has a similar notion related to its purchases through the ESM. If such a plan were announced today, the ECB would have to pay offers when it buys the debt of Italy and Spain, at the moment it is being given on the bid. It should also be noted that the yields seen in Italy and Spain are now much closer to those seen in 1996 before those countries' entry into the Euro. I do not believe this is a coincidence.

So what will the landscape look like when the dust settles? All countries in the Euro will have debt to GDP ratios at or below 60%. All debt above those levels will be held by the IMF-managed fund, with collateral pledged and ring-fenced by the technocrat-led governments. Europe will recapitalize banks through the EFSF, but they will be recapitalizing banks that have survived this live-fire stress test, at levels that make sense. The terms of these recapitalizations will be favorable to the EU, much as the Buffet investment in Bank of America (NYSE:BAC) was for Buffet. The ECB and the EU are forcing banks into a position more favorable to the new investor, less so for the current shareholders. Europe will finally enter into a Fiscal Union and Euro-bonds will flourish. While Merkel states her disinterest in Euro-bonds today, I believe it is because if she supported them today, then governments would be less willing to take care of their own issues. She is managing the 'free-rider' problem masterfully.

Out of moments of great stress come great opportunities. Merkel, Sarkozy, the ECB and the European Union are taking advantage of this stress to pass sweeping changes across Europe. I do not see the Euro collapsing, nor do I see its imminent collapse. Rather I fervently believe a stronger Europe will soon be announced. While the market is calling for the ECB to 'print money' I believe it is more likely that the US Federal Reserve would announce QE3. ECB printing would enhance the feared free-rider problem that Merkel is so furiously managing. ECB printing would see the US Dollar strengthening, something that would see a steep downdraft in US equity markets as a stronger US Dollar sapped global demand for US exports. A stronger US Dollar would also translate into a weaker Chinese Yuan, and so amplify the 'global imbalances' that are so often discussed at G20 meetings.

While markets see this week in a dire light I believe out of this will come significant change throughout Europe. Time will tell. December 9th will be significant.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.