A few weeks back, Mario Draghi "saved" the euro by pushing through a program of unlimited bond buying. Just this sort of extreme measure was required to convince investors the euro is not going away.
We know that Draghi's actions were effective, furthermore, based on not just the sharp drop in Spanish and Italian bond yields, but Germany's horrified reaction.
In order for the euro to truly be out of harm"s way, the confirmation of an aggressive printing press mandate - an emergency debt monetization measure - had to be implied. This is what Draghi achieved, causing Bundesbank President Jens Weidmann to mutter about "the devil's work."
But here's the thing. Draghi and the ECB (European Central Bank) can offer up printing press palliatives, but they cannot save the euro from democracy.
When austerity begets unrest, in other words, there is no central bank action that prevents protesters in gas masks from throwing firebombs at police…
The spirit of where we are now, vis a vis Greece and Spain, was communicated by labor leader Despoina Spanou: "This strike is only the beginning in our fight."
The beginning as in, nowhere close to the end of Europe's troubles…
Even if the ECB credibly communicates its intention to defend the euro at all costs - which it appears to have done - there is still the question of what bitter harvest periphery country austerity shall reap. Half the youth in Spain and Greece have no job and no future. Middle-aged Greeks and Spaniards, once comfortably middle class, are now pondering a rapid descent into poverty.
And all of this is blamed, rightly or wrongly, on harsh austerity policies enforced by "outsiders," e.g. Brussels and Germany…
The outsider element is a highly combustible component because it feeds so aggressively into feelings of solidarity and nationalist pride. When the people are suffering and in major pain, as Greeks and Spaniards are now, the political response from would-be revolutionaries is made that much more potent via access to "us and them, good and evil" stump speech terms.
We the beleaguered citizenry are good… those who impose such chains are evil, etc…
In fact, as some others have observed, the fiscal chains of the euro are comparable to the chains of the gold standard roughly a century ago, in terms of forced monetary discipline fomenting intense pain and, ultimately, the threat of violent unrest.
To understand this connection, it is worthwhile to revisit the William Jennings Bryan speech of 1896. Consider the context, as provided by historymatters.gmu.edu:
The most famous speech in American political history was delivered by William Jennings Bryan on July 9, 1896, at the Democratic National Convention in Chicago. The issue was whether to endorse the free coinage of silver at a ratio of silver to gold of 16 to 1. (This inflationary measure would have increased the amount of money in circulation and aided cash-poor and debt-burdened farmers.) After speeches on the subject by several U.S. Senators, Bryan rose to speak. The thirty-six-year-old former Congressman from Nebraska aspired to be the Democratic nominee for president, and he had been skillfully, but quietly, building support for himself among the delegates. His dramatic speaking style and rhetoric roused the crowd to a frenzy. The response, wrote one reporter, "came like one great burst of artillery." Men and women screamed and waved their hats and canes. "Some," wrote another reporter, "like demented things, divested themselves of their coats and flung them high in the air." The next day the convention nominated Bryan for President on the fifth ballot.
And here is the climactic takeaway from the speech itself:
You come to us and tell us that the great cities are in favor of the gold standard. I tell you that the great cities rest upon these broad and fertile prairies. Burn down your cities and leave our farms, and your cities will spring up again as if by magic. But destroy our farms and the grass will grow in the streets of every city in the country.
My friends, we shall declare that this nation is able to legislate for its own people on every question without waiting for the aid or consent of any other nation on earth, and upon that issue we expect to carry every single state in the Union…
…If they dare to come out in the open field and defend the gold standard as a good thing, we shall fight them to the uttermost, having behind us the producing masses of the nation and the world. Having behind us the commercial interests and the laboring interests and all the toiling masses, we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold.
One can picture a modern-day Grecian or Iberian WJB, thundering to a roaring crowd: "You shall not press down upon the brow of Southern Europe this crown of thorns. You shall not crucify mankind upon a cross of euros!"
The dawning horror for slow-footed investors this week - via amplified chaos in Greece and Spain - is the following chain of realizations:
- The eurozone crisis was not solved by Draghi's victory over the Bundesbank.
- Indeed, the can was not even kicked down the road very far.
- Even if the euro survives, severe recession / depression is in the cards.
- Brussels and Germany will be blamed as austerity-imposing outsiders.
- Populist backlash - the democracy threat - could bring severe consequences.
What next for the eurozone, then?
A Greek exit, announced out of nowhere - for that is the only way they could do it, to forestall capital flight - would invite immediate panic and chaos. While Spain is less likely to exit, PM Rajoy has shown a willingness to negotiate with a figurative gun barrel pressed to his own temple.
A solution to Europe's democracy-fueled austerity problems, then, would likely involve something even bigger than an unlimited bond-buying bazooka… more along the lines of a fiscal intervention suitcase nuke.
And if Germany almost puked at the prospect of printing euros to buy sovereign paper, imagine its reaction to a suggestion of wading hip deep into Greek and Spanish government expenditures… paying out for salaries and welfare programs… blurring the line between fiscal and monetary policy beyond all discernible recognition.
One can picture the vein in Weidmann's forehead exploding.
What's more, there is talk that a Greek exit, aka "Grexit," would be manageable. But who really knows for sure? There were also confident opinions that a Lehman failure would be manageable, and even desirable as a sign of market discipline. (Oops.)
Not to mention Spain, of course, remains a potentially bigger problem than Greece. Spain is too big for any serious talk of an exit. Besides, German banks have huge risk exposure to Spanish assets, the value of which would plummet on an auto-devaluation euro exit. Via WSJ:
As Europe races to restore confidence in Spain's finances and the euro, Germany has another reason for urgency in resolving the crisis: the health of its own banks.
German lenders have the highest exposure in Europe to Spain, at $139.9 billion, of which $45.9 billion alone is exposure to banks, according to the Bank for International Settlements.
…German banks have largely hedged or disposed of their holdings of Spanish government debt, but they remain heavily invested in Spanish financial institutions, commercial real estate and in other businesses hit by the crisis.
Spanish PM Rajoy knows all this, of course, which is why he is holding out on bailout acceptance as long as possible (as of this writing) in order to better control the terms.
Impact on the euro
How will this all impact the euro? At some point, we believe, conventional wisdom, re, the dollar and the euro, will take a frying pan to the face.
The basic meme that has kept the euro strong and the dollar weak is hawks vs doves: Whereas Europe's central bankers are hawks, relatively speaking, the Fed holds the dove-of-doves crown and thus the dollar should be shorted.
This viewpoint is rather myopic, however - at least in our humble opinion - in respect to overlooking the fact that Europe is basically screwed whereas America is not. The U.S. certainly has its own serious issues - looming fiscal cliff, persistent unemployment etc - but these pale in comparison to both 1) the dead-of-winter economic climate Europe faces and 2) the dilutive measures that must, MUST be taken vis a vis the euro and fiscal policy, not just monetary policy, if democratic populist backlash is to be kept from tearing the eurozone apart.
This severe craziness explains, in part, why we see a world where the short side is more appealing than the long side in the coming months. Stimulus measures and hail Mary policy actions are subject to the law of diminishing returns. And the true underlying problems plaguing Europe, China and the U.S. are nowhere near solved, even as the big three's respective cans get kicked into a blind alley.
Constructive Thoughts on Metals
In light of the above, let us now take a moment to change our basic stance on the outlook for metals (both precious and base).
Prior to now our general macro stance on metals has been neutral to bearish. The idea that metals would simply hop a ride on the stimulative inflation train seemed too pat… too simplistic… like a piece of cheese left out in a mouse trap.When a trade connection is both highly obvious and highly popular, in other words, experience tells you to question it.
And we still retain a healthy amount of skepticism, as well expressed by this cartoon (hat tip Josh Brown):
To briefly expand on a "what if" metaphor we have used in the past (with inspiration credit to Hugh Hendry):
What if the amount of stimulus is actually far too little to make a dent in the huge deflationary forces engulfing the global economy?
What if the destruction of trillions of dollars worth of credit, the evaporation of monetary velocity, and the looming dead weight of overcapacity writedowns stands to dwarf whatever piddling efforts the central banks have made (piddling relative to the magnitude of the problem)?
What if, in other words, the Fed's stimulative actions thus far, as a counter to deflationary realities, are the rough equivalent of throwing a mattress into a volcano?
The "deflation before inflation" meme has always seemed logical to us, especially given the seemingly booby-trapped faith in a one-to-one correlation between money printing and inflation pressure driving metals prices up, even in the absence of wage inflation or general economic pick-up.
So, for the above reason, we have not been on the bullish metals train (precious or otherwise) for a good while. (With that said, we have not lost any money trying to fade metals either. Our positioning has netted out to more or less neutral / flat, with a handful of profitable short forays.)
Now, though, we are growing more constructive on the metals for the following reasons:
- Price action in various base metals producers is curiously strong.
- Central banks are showing a tendency to "pre-panic," i.e. skip ahead to emergency measures.
- The seriousness of the China / Europe story lines points to one basic solution…
- Print like hell!
To sum up, our distrust of overly simplistic memes - and the tendency of markets to confound popular opinion - has kept us more or less non-bullish on metals for most of 2012.
But now the big drivers are resolving in such a way as to perhaps say: "Yes Virginia, the printing press tidal wave is coming… and there is nothing anyone can do to stop it…"
Our shift in stance is further underscored by the increasing drumbeat for more printing press action, as expressed by respectable sources like Tim Duy, who writes the following in conclusion to his piece "Why I agonize about the zero lower bound:"
Lifting off the zero bound probably requires a high degree of cooperation between the fiscal and monetary authorities that may, gasp, require some outright monetization of government debt. Such monetization is what Bernanke advocated for Japan, but this advice fell on deaf ears. Because such cooperation is feared, it is essentially off the table. For now. But what I think will be the case is that instead of small amounts of cooperation now, we are setting the stage for large amounts in the future. Debt reduction via inflation will come; the longer we wait, the more disruptive it will be.
Such thoughtful, careful, technocratic cooperation between monetary and fiscal authorities, however, is no where to be found. In the US, Europe, and Japan, at best we have is monetary authorities trying to offset real and expected fiscal austerity. That path, I fear, only leads us deeper into permanent zero bound territory.
Bottom Line: 2015 is too long to wait to emerge from the zero bound. Policymakers need to make efforts to normalize the economic environment a priority. That may require a level of fiscal and monetary cooperation that today seems to be unthinkable. But if gets to the point where central banks are pulled kicking and screaming into such cooperation (the European Central Bank may be the first to explicitly monetize government spending; I suspect it will be the only way to keep Greece in the Euro and live up to Draghi's pledge that the Euro is permanent), then I think we will all wish we had engaged in such cooperation sooner than later.
Hmm. Well okay then. The smart and responsible lever-pullers (smart and responsible in the eyes of society anyway) are slowly coalescing on a Paul Krugman view - that "the big coordinated print" is all we've got left in terms of tools in the tool shed. Time to put away the monetary policy bazookas and bring out the fiscal policy suitcase nukes? Duy and others are increasingly moving the needle to "yes!"
If this is the prevailing view among academic intelligentsia and policy-setters proper, then yes, the "deflation then inflation" paradigm may be invalidated by an urgency-inspired policy end-run straight to the inflationary part… in which case various hard asset producers could once again prove excellent vehicles for medium-term investment and general bullish trades.
In all things, of course, we are nothing if not nimble… and if this general broad-brush thesis is right, we ain' seen nothin' yet in terms of where gold, silver and potentially other hard assets could go. If the checkered flag is down, let the metals madness begin!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.