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French President Nicolas Sarkozy has suggested that the availability of unlimited funding by the ECB solves the PIIGS sovereign debt problem since PIIGS banks can use the generous central bank funding to purchase the PIIGS debt of their respective home countries. This gambit has variously been called the “Sarko Trade,” the “LTRO carry trade” and the “Corzine Trade.”

There are two schools of thought on this:

  • Banks are not interested. European banks have dumped 65 billion euros worth of sovereign bonds in just the past nine months. They have done this in large measure due to the risks – real and perceived – that these bonds pose to their business. Banks will not increase exposure to assets that are perceived by the market as increasingly toxic. Indeed, doing so could exacerbate the current run on the banks.
  • Banks have no choice. If PIIGS sovereigns go bust, the European banks have a 100% certainty of bankruptcy. If the banks buy PIIGS debt in an effort to prevent PIIGS defaults, this might cause them problems, but at least the probability of bankruptcy for the banks would be less than 100%.

Option #2 may make sense from a game-theoretical point of view. However, I do not believe that bank managements will adopt this kamikaze philosophy. One reason is simply bank culture – few banks are as reckless as MF Global. And the example of MF global is not exactly one that many banks will want to emulate at this point. Another reason is that many banks may decide to call the ECB and German bluff, understanding this to be a situation of “mutually assured destruction.”

Option #1 is probably closer to the truth. Banks will mainly take advantage of the LTRO funding to simply replace the loss of private funding and insure that they are able to roll over their maturities. They are likely not looking to add additional leverage, but mainly see the ECB facility as a means of avoiding hasty liquidation of assets due to loss of funding.

Having said this, through a variety of measures, I think European sovereigns will find ways to avoid default in the coming weeks. Thus, I do not believe that the availability of short-term financing for sovereigns is the key issue at this point.

Investors should not take their eye off what I think is the ultimate issue that drove this crisis in the first place and which will soon enter into a second and more intense stage. Specifically, European economies are contracting very sharply and this will make fiscal targets impossible to meet. PIIGS and other countries will have to ask for forbearance as well as additional funding to cover the shortfalls. Germany and some other northern countries will refuse. A highly acrimonious political confrontation within the EU will ensue that will take the crisis to the brink. By then, global markets, including the S&P 500, will be down 20% from current levels.

Conclusion

In the short run, European sovereigns can find ways to fund themselves with or without the benefit of the so-called “Sarko Trade.” However, there is a larger issue that lurks: Recession and its impacts on national budgets. I believe that this will be the issue that ultimately triggers the unfolding of a second stage in this crisis.

It is my view that all but the shortest-term traders should refrain from attempting to play the equity market on the long side through individual stocks or equity market proxies such as SPDR S&P 500 ETF Trust (NYSEARCA:SPY), SPDR Dow Jones Industrial Average ETF Trust (NYSEARCA:DIA) or Powershares Nasdaq-100 Index Trust (NASDAQ:QQQ). I believe that investors with longer time horizons should raise cash and avoid purchasing and/or holding equities - even those that appear attractive such as Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) and Pepsi (NYSE:PEP).

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

Source: The Sarko Trade: Will Banks Double Down On PIIGS Debt?