The Market's Bipolar Tantrum Will End Soon

Includes: FXE, SPY
by: Bo Peng

There are four basic moods for the market:

  • Bullish
  • Bearish
  • Bored
  • Bipolar

Over the past three weeks we've gone from Bearish (worries over the eurozone) to Bullish (after a coordinated central bank swap line) to Bipolar (after the Brussels summit). It's been so exciting it makes one yearn for Boredom.

Unfortunately, I doubt we'll get it, at least not any time soon. After we spent days trying to decide whether we should be excited or disappointed by the Brussels summit, finally the almighty rating agencies hath spoken and even the dumb money knows it should be disappointed. Normally this should signal a contrarian end to bearishness. But more danger is lurking beyond the horizon.

Zerohedge has done a great job, despite the unrelenting hyperventilation, focusing on the theme around hypothecation and its potential impact on counterparty risk chain reaction and loss of confidence in the shadow banking system. But the broader theme was on the shadow banking system and how the funding crisis in Europe could push it to the brink of collapse, much like what happened around Lehman collapse. Now Bloomberg and the NYTimes (everyone in the MSM by now, of course) have both picked up the theme:

With the region’s leaders gathering in Brussels in their latest bid to shore up the euro, the European Banking Authority announced that over all, banks needed to raise 114.7 billion euros ($152.7 billion) in the event the debt crisis was not resolved soon. That was more than the estimate of 106 billion euros in October.

The banking authority’s assessment showed that banks in Germany, Italy and Spain would have to raise more capital than previously thought, while banks in France had all they needed. In all, the stress tests showed that 31 of 71 banks needed stronger reserves.

Banks (I find it intellectually insulting to qualify modern banks with nationality, whereas the only thing that matters is which branch is subject to which jurisdiction -- this is yet another indication that the perfectly good 08 crisis has been wasted) will have to either sell assets or raise capital (I wouldn't even bother considering them going to the state for money -- for crying out loud, if the states had the money, the banks wouldn't have been in this hole to begin with!).

The latter is highly improbable. Whatever amount they manage to raise, the gap must be filled by shrinking the balance sheet, only with a multiplier of 20, assuming a 5% capital ratio (it's not clear to me what the required ratio is -- this is based on EBA's latest and greatest stress test, don't laugh, not Basel III). Ballpark: assuming they raise half of the required capital, they'd have six months to sell 115/2*20 = 1150 billion euros, a big part of which is probably assets of questionable quality, into a dismal market.

As survivors of 08, we all know well that by nature of highly leveraged Credit Society, one euro/dollar pulled out of the system causes 10 euros/dollars withdrawn somewhere else, which may stop there at the first iteration or it may go to 100 at iteration 2 and so on. Whether the positive feedback loop becomes a vicious deleveraging chain reaction depends on some unknown threshold, partly real and partly psychological, being breached. 11500 seems like a big number, in billions euro, probably enough to overcome the threshold all by itself, without any help from iteration 2.

Considering that the notice was given on 12/8 and bankers all know well that deleveraging is like fire in a theater, it's quite probable that the stampede has already begun. The fact that gold has come down despite of (or because of, if you may) recent uncertainty, especially on Monday, supports this hypothesis -- or is it hypothecation in the new lingo -- since gold has been increasingly accepted, but more importantly deployed, as the safe collateral in the new world of disappearing AAAs.

Speaking of AAAs, it's funny how I almost forgot about it, at least some of the 17 eurozone sovereigns (or ex-sovereigns) will be downgraded by S&P. They specifically mentioned in the negative watch announcement that any further decision would depend on the summit outcome. And now they are saying the summit is a disappointment. The only interesting question at this point is whether Germany and France will be shot. Considering the German government is considering giving banks capital, I would not write off the possibility of Germany being written off. Why the world still gives credit agencies' opinion so much value, I shall die without knowing. Life is full of mysteries.

But while you're at it, S&P, don't forget to factor in the deleveraging task faced by European banks, and the new stress test on US banks planned by the Fed:

American banks hold smaller amounts of European sovereign debt. But the Federal Reserve is also planning new tests to gauge the ability of banks in the United States to weather any further deterioration in Europe, which appears to be on the cusp of a recession.

So there, a collateral squeeze, a funding crisis, a deleverage wave, a sovereign solvency crisis, and a bank solvency crisis, all coming together as one big happy family.

But, like the annoying shopping channels, there's more!

About the only concrete result of the Brussels summit is that they agreed for the ECB to lend some money to IMF which, after levering it up with money from other countries, would lend it back to eurozone governments in trouble. (When you're as good as Europeans in making treaties, you really need to be as good as Europeans in finding loopholes.) Whatever those "other countries" may be, the US will not be one of them.

But without the US taking the lead AND giving the go ahead to IMF, in addition to the UK being very publicly snubbed, it's doubtful that anyone else would make significant contributions. Yes, Obama has strong incentives to prevent the euro crisis before election. But if Bernanke wants to comply, he'd better tread very carefully. Until the euro crisis actually begins, the Fed's action would be closely scrutinized by Republicans and the media, which finally got a sliver of its long-lost backbone back after the Bloomberg analysis on the Fed's 08 lending.

There are indeed many signs that the US is slowly recovering. But I don't think anybody even dreams to argue the case for US-Europe decoupling. We're still joined at the hip, with the hip being first and foremost the banks. The eurozone sovereign debt crisis has never been truly about the sovereigns; it's always been about banks. When the euro can becomes too full to be kicked further down the road, the US economy will be affected, along with BRICs and mortars.

In summary, the good news is that the current Bipolar mood cannot last much longer; the bad news is manic depression will follow.

Disclosure: I am long GLD and short SPY.