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Erwan Mahe
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Erwan Mahe is an asset allocation and options strategies adviser for the largest European Asset Management firms. Publishing macro-economic research, he has been managing leading European financial brokers since 1987, and sold his company, Paresco Futures, to the OTCexgroup in 2005. He is now... More
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  • " Would you please stop this texan nonsense?" An Open letter to Mr Spellman.
    Important Notice: this paper is not political. I just trie to correct some blatant  misstatements about the Greek Sovereign drama. This drama has huge consequences for investors, as it is nowadays one of the main risk-risk off light switch!
     
    Good morning Mr Spellman,
     
     
    Please do not take badly my title about Texan nonsense, I have many customers and friends up there, I just thought it was a good teaser for this mail! And it is true that your state offers the fiercest and most vocal commentators on this subject…
     
    I have just read your last letter about Greece and Europe. Link: ‘As Greece Goes, So Goes Europe: How the Unthinkable Happens
     
    It seems you have a much better understandings of the economics and politics at stake here than many of your peers, but I felt compelled to send you anyway the last paper I wrote for our institutional customers, regarding this very subject.
     
     
    I would first like to point out a few items of your report that I think quite surprising, if you may:
     
     
    “If the debt is refinanced over the next four years, when due at the present market cost of funds, a tax bite of more than one-third of ALL Greek income would be required just to pay interest on its government’s debt.”

    The price of Greeks bonds on secondary markets is totally irrelevant.
    What you must take into account for your calculations is the interest rates that public creditors today charge to Greece when they fill the gap that private savers left wide open.
     
    The last published rate was 4.2% for a 7.5 years loan maturity for the UE part. Link : ‘Eurozone leaders lower Greek bailout interest rate, extend maturity
    And 3% for the IMF part. Link WSJ: Who's on the Hook for the IMF's Greek Bailout?
    And the last auction of 3 and 6 months Greek Tbills, the 10th of Mai, were printed at 4.06% and 4.88% respectively. Link WSJ: Greek's T-Bill Auction Overcomes Default Fears .
     
    I do not want to imply that these rates would still be available without official pan European support. If ever the latter was to disappear, Greece would default, and go bankrupt, obviously. And I do not want to say that Greece will succeed in eventually averting default even with these lower rates, if they cannot generate any meaningful revenues in the years to come.
    But if, as you did, one tries to calculate what will be the cost of debt for Greece, relative to income, I suppose one should first of all use actual rates, and not ones from secondary markets quotes, that have nothing to do with current Greek way and cost of borrowing ?
     
     
    “Seeing this possibility, in the last year many banks have sold their Greek debt to the ECB, which was willing to pay the full face amount as part of their Rich Uncle support role. To the extent the ECB cleared the Greek debt from commercial bank balance sheets, …”
     
    Is this really the narrative which is making the rounds in Texas?
     
    The ECB did not buy Greek debt from commercial banks at ‘full face amount’. NEVER! It purchased it on the secondary market, at very depressed markets prices, on average, depending on maturities, at between 80% and 60% of par. These prices are even lower now, since it stopped its purchases and since Me Merkel insisted so much on private sector involvement in the support plan’s costs.
     
    And it therefore obviously DID NOT  ‘clear(ed) the Greek debt from commercial bank balance sheets’!
    The whole ECB Securities Market Program (NYSE:SMP) amounts today to 75 B €, and the ECB bought also other peripheral countries bonds.
    Knowing that the total outstanding amount of Greeks bonds is nearer to 270 B €, you understand how your statement about ‘clearing bank balance sheets’ is misleading…
    Once again, I do not want to stress this point because I do not agree with you about the consequences of a Greek default on the European banking system, on the contrary. But all these factual errors will just confuse any reader who tries to make his own ideas about the current European upheavals.
     
    I will gladly add you to the diffusion list of my Thaler’s Corner, hoping that it will help you think about us poor European with accurate data.
     
     
    Best Regards.
    Erwan Mahé.
     
    PS: please be kind to my English writing, I am a French native.


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

    Additional disclosure: Disclosure : Long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Grece 1 Y and 8 Y bonds, Thaler's Corner.
    Jun 02 2:10 PM | Link | Comment!
  • The huge and highly dangerous Austrian School experiment!
    Some of the things I have heard in recent days leave me utterly speechless, which explains my absence in the first half of this week.
    It would appear that I now completely stand by myself with my AIG-style bail-out solution (extension of debt maturities, collateralisation, reduction in nominal interest rates as opposed to restructuring) to save Greece (and the eurozone?), although I still see no other non-destructive remedy for this situation. I must admit that I was bitterly disappointed to read of Martin Wolf's conversion to the belief in the inevitability of early restructuring in his FT opinion piece two days ago: « The Euro Zone's Journey to Defaults ».
     
    I may be alone (and stuck with my Greek government bonds) on this question, but I'll get over it. I went through much of the same in H2 2007, the major difference being that no type of macroeconomic analysis has any bearing this time around, as the matter has fallen into the highly unpredictable domain of politics. Of course, nothing stops us from developing our own opinions, but contending with political swings is quite a bit more volatile than economic analysis.
     
     
    I have thus decided to return to fundamentals today, given the giant Austrian School wave:
     
    ·         The Tea Party in the US is fuelling popular hysteria about unsustainably high government deficits, with Paul Ryan proposing plan made for fantasyland(NY Times : Paul Ryan’s Multiple Unicorns).
    ·         The austerity cycle launched in the United Kingdom (Telegraph :  UK austerity measures to check growth).
    ·         The German constitutional law (Federal Cabinet approves updated German Stability Programme).
    ·         The French plan to call a joint Senate and Assembly session to adopt the same type of law into the French constitution (Fillon accuse le PS de fragiliser le “triple A” de la France).
    ·         The slew of austerity plans in eurozone peripheral nations, which will guarantee that they remain in a deep recession characterised by persistently high unemployment for a long time to come (Can PIIGS Dance the Austerity Two-Step?).
    ·         The BOJ's refusal to openly finance Japanese rebuilding plans, due to fears of a negative reaction from bond vigilantes and inflationist monetization, which really takes the cake in a country ensconced in a deflationist trap for over a decade (BOJ's Nishimura Says Bank Must Avoid Creating Image of `Debt Monetization'). You might check out this instructive report written by Adam S. Posen in 2002: Deflation and the Bank of Japan.
     
     
    All these austerity plans are being set up to fight mounting government debt loads whose exponential growth, leaders inform us, would imperil countries by either pushing them to bankruptcy (default), hyperinflation or the crowding out of private-sector initiative. 
     
    So let's take a closer look at each one of these alarming assertions.
     
     
    Deficits and interest rates
     
    Deficit growth will push up interest rates and thus lead governments to default on debt, once the part of government spending dedicated to interest payment becomes unsustainable. Before we start, bear in mind that it is interest payment/GDP that is the key ratio, not debt/GDP.
     
    From a theoretical standpoint, this assertion does not account for the fact that budget deficits mechanically creates private savings (be it in the country itself or abroad) denominated in dollars (in the case of the US) which is then invested, either in government debt instruments or ends up in surplus bank reserves, which, in fact, pushes rates downward!
    Moreover, such an assertion ignores the reality that it is technically impossible to force a country with currency sovereignty into debt default, since its debt obligations amount to promises to pay credits in its own currency whose marginal production costs is zero!
     
    As you can see in the graph below, which compares US budget deficits with interest rates paid on 5-year government bonds (average maturity on US government debt) since 1971, this assertion is flatly contradicted  by reality of past performance.
     
    During phase, 1, 3 and 5, which were periods of periods of deficit growth, interest rates declined. At the same time, interest rates increased during phases 2 and 4, when budget deficits declined. This illustrates that the budget deficit's level, like that of interest rates, in reality depends on the level of economic growth.
     
     
    American budget deficits and interest rates on 5-year government debt
    Perhaps even be a negative correlation!
     
     
     
     
    Deficits and inflation
     
    According to those who push austerity, come Hell or high water, deficits create inflation, either due to the economically inefficient government spending or due to the monetization of public debt by central banks.
     
    Aside from the crude and approximate usage of the term, monetization, bear in mind that the extraordinary measures taken by the Fed, the BOJ and the BoE represent, in fact, an asset swap in investors' balance sheets between bonds and cash, which end up in the Fed in the form of surplus reserves. In any case, these reserves are useless for commercial banks and do not create more lending (loans create deposits !). For that to occur, there needs to be real credit demand, which meet the credit requirements stiffened considerably since 2007.
     
    If central banks directly paid off government expenses by real money creation, we would indeed be confronted with monetization and the risk hyperinflation to the extent that the other inflation factors are present (absence of output gap, inflation expectations, etc.).
     
    In any case, from a theoretical viewpoint, the graph shows that there is no relationship between inflation and deficits, other than a somewhat negative correlation, as seen in all five phases.
     
    Inflation is also much more dependent on growth than on anything else. When growth collapses, budget deficits rise (automatic stabilisers). Under such situations, it is hard to see the slightest inflationary surge.
     
     
    Core PCE and budget deficits
    Perhaps even a negative correlation!
     
     
     
     
    Deficits and crowding out
     
    The very construction of this phrase is stupid, since a hike in a country's budget deficit automatically creates wealth of private-sector economic agents!
    Remember: Pr = Cc + I + Def + Bal – Sw, i.e.                                                                           
    After-tax company profits =  Consumption fuelled by capital income + Investments + Budget Deficit
    + Trade Surplus  – Employee Savings.
     
    So instead of following the Austrian hearse, so full of morality but so devoid of life, check out this last graph, which compares interest rates paid by firms with a high grade investment rating in the US with budget deficits.

    Surprise! surprise! As you can see, the results run totally contrary to the "crowding out" crowd which Investopedia defines as:
    “Governments often borrow money (by issuing bonds) to fund additional spending. The problem occurs when government debt 'crowds out' private companies and individuals from the lending market.
    Increased government borrowing tends to increase market interest rates. The problem is that the government can always pay the market interest rate, but there comes a point when corporations and individuals can no longer afford to borrow.”
     
    Here we have a case of reality contradicting a very commonly held view: budget deficits decline and interest rates increase, but when they skyrocket, interest rates decline.
     
    High Grade Corporate Yields and budget deficits
    Aside from the cash crunch at the end of 2008/beginning of 2009, interest rates paid by corporations have been declining as budget deficits mount!
     
     
     
     
     
    Western economies have now launched austerity plans to boost growth, and I fear that the path taken will lead us to some very painful surprises.
     
    However, given that this topic touches on some very personal opinions and values, I will not go any farther today. My purpose was just to provide some figures and graphs to debunk some very popular ideas in the hope that it may prevent you from falling victim to them and their consequences.
     
    Let's end with a quote by ArcelorMittal CEO Lakshmi Mittal from this morning's FT (Mittal calls on Europe to follow US lead).
    There have been two approaches [to boosting the economy]: the European way aimed at combating inflation and the US stance which is aimed at growth, and I like the US approach better”.
    “The austerity measures that we have seen are having a damaging impact on growth.”
     
     
     


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

    Additional disclosure: Long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Grece 2 Y and 10 Y bonds, Thaler's Corner.
    May 13 5:31 AM | Link | 2 Comments
  • The ECB dances to its own tune, and badly
    Following the numerous comments received on the 28 April Thaler's Corner (‘It Takes 2 to Tango: The Fed and the ECB in a rivalry of bad faith’), which was picked up by Bloomberg in its Fed and ECB columns, I looked deeper into the subject matter and have come to the conclusion that my parallel between the Fed and the ECB does not quite hit the nail on the head.
     
    It is true that the two central bank are engaged in two different roles, with the ECB taking a harder stance in Europe and the Fed in the United States and many other central banks following very accommodative monetary policies, as illustrated in the graph below.
     
    Indeed, the United Kingdom and Japan, the two other economic pillars of the developed world, are maintaining benchmark interest rates at rock bottom levels, as the ECB almost alone continues to promote restrictive monetary policies.
    Some will respond by pointing out that Canada, Sweden and Australia have also adopted more restrictive monetary policies in recent months, but their economies are exposed to commodity markets and the economic overheating fuelled by the recent surge in commodity prices required a tightening of monetary policy in those countries. In any case, their economies are either too small, as a percentage of worldwide GDP, or their currencies do not have sufficient weight to significantly impact the rest of the world.
    As for emerging countries, like China, Brazil and Vietnam, which just upped interest rates this morning for the fifth time this year, to 14%, that has nothing to do with the eurozone. The latter area is hardly undergoing the same sort of steep economic growth, but instead faces a huge output gap, with an average unemployment rate of 9.90 and an industrial production utilisation rate three percentage points below the average non-recession rate.
     
    The latest report from the Market News  agency seems to confirm that our beloved central bank just can't wait to get started! It may, according to MNS, even hike rates again this June, instead of July, as previously expected, and by as much as 50 bps! (we don't adhere to this scenario though) It is hard to believe that those responsible for monetary policy woudl be so determined to engage in creative destruction of the single European currency, but given Trichet's continued defense of his disastrous rate hike of July 2008, a continuation of such wrongheaded policies should come as no surprise.
     
    One of the reasons I decided to rehash this topic and provide the graph below, which compares the performance of 6-month treasuries in Germany (euro benchmark), with those of the United States, the UK and Japan, is the incredible T-bill issue yesterday evening in the United States.
    The US Treasury issued $28 billion in T-bills at the whopping rate of … 0%!!
    No, there is nothing wrong with your screen, which needs not adjusting! Remember, we are talking about a country that has just been downgraded to Negative Outlook by S&P. They also issued 1-year debt at 0.19% and 3-month at 0.01% !
     
    As you can see in the graph, the same trend is observed in the United Kingdom, at 0.37% on 6-month debt, down from 0.70% just a few weeks ago, and in Japan, 0.12%, without any chance of a hike following the BOJ injections in the wake of the Fukushima tragedy. In the United States, the rate fell to a record low 0.08%.
     
     
    In the meantime, since Mr Trichet's well known comments of 13 January, the interest rates European states must pay to finance their budget deficits have been continuing rising, with the 6-month rate climbing to 1.17% this morning from 0.50% at the beginning of the year.
    So let's review Trichet's remarks at the ECB press conference of 13 January and later to German TV station ZDF, just in case his message has gone unnoticed. (By now, I wonder if he is not looking for a nice little retirement in the Black Forest)
    ·         Very close monitoring is warranted.” (code language indicating rate hikes ahead, with "mission accomplished" 7 April, given the first 25-bps rate increase).
    ·         Proved in past not pre-committed, by deeds not words”. “Remember in July 2008, we judged appropriate to hike rates”. (help!!)
    ·         The European Central Bank will do everything to ensure price stability; including hiking interest rates should that be required.”
     
    6-month sovereign debt yields: Germany vs US, UK and Japan
    The empire strikes back 
     
     
    This super antiquated monetary approach, recalling the gold standard days, is increasing considerably the debt costs of eurozone countries. At a time when countries are trying hard to reduce spending, under pressure from German leaders and credit rating agencies, this new surge in their interest payment expense item is bad news indeed.
    Bear in mind that from the standpoint of a government's solvency, it is not total debt-to-GDP that counts, but the ratio between a government's total receipts and interest expense. It is for this reason that I have repeatedly suggested indexing the rates paid by PIGS nations dependent on bail-outs at the 3-month Euribor rate to prevent the ECB from further messing things up.
     
    Others certainly go along with this line of reasoning, such as BOE chief, Mr King, who declared yesterday at the European Parliament: 
    ·         The economic consequences of high-level indebtedness now would become more severe if rates were to rise, It is the main reason why interest rates are so low.
    ·         The problem of leverage, the sheer volume of debt in the economy, is still very large and this poses massive macroeconomic challenges”. “I think these macroeconomic challenges will last many years.”
     
    But that's not all! This widening spread between between the risk-free rates paid for short-term eurozone treasury instruments and those of its major trading partners is having a direct impact on the euro exchange rate, as you can see for yourself in the following graph. And that's leaving aside the more attractive rates on 6-month instruments of eurozone government issuers deemed a bit less solid than Germany, like Belgium 1.37%, Austria 1.53%, Italy 1.66%, Spain 1.75%, Ireland 5%, Portugal 6.30% and Greece 7%.
     
    Since 13 January, the euro has been going in the same direction: from 1.29 to 1.49 vs the dollar, from 0.83 to 0.90 vs the pound sterling and from 107.22 to 120.80 vs the yen. I realise that German exporters are insensitive to the euro's parity, given the level of their product differentiation, but this is a huge blow for PIGS nations as they lumber under the weigh of draconian austerity plans and an exceptionally high unemployment rate!
     
    Whether it be the Portuguese economy, which suffers from weak product differentiation (textiles and agriculture), that of Greece, which is taking the full brunt of the euro's appreciation (shipping, tourism and agriculture), or that of Ireland, which is suffering as its English neighbours take advantage of their competitive edge, the current hike in the euro is deadly.
     
     
    Euro vs the dollar, pound sterling and yen
    Who do we thank?
     
     
     
    All this (and more) would be justifiable if only a series of interest hikes by the ECB could grow cotton, extract more oil (while preventing the Saudis from exacting their price) or dig up more copper.
    The only consequence of this deformation of monetary policy will be the continued appreciation of the euro and the impoverishment of the eurozone member states via a bloating of their debt financing costs.
     
    However, there should be no need to really punish European states, even from a monetarist standpoint, as can be seen in the last graph below.
     
    This morning, eurozone retail sales for March were published. Expected at 0% YoY, they declined-1.7% !
    We are now back to negative movements equivalent to those of 2008-2009, which is hardly surprising. Given all the media reports of the crumbling of the Monetary Union and the upcoming breakout of new bail-out request, it is hardly surprising that consumers are cautious.
     
    If the ECB were to focus a bit more on the major aggregates, it would worry instead about the continuous decline in consumer credit, as seen in the graph, down 0.90% YoY. They have been in continuous decline since the spring of 2008, something that we did not even see in the slump of 2003.
     
    Retail sales and consumer credit on the eurozone
    Right: what a great time to increase interest rates!
     
     
     
    That makes for a pretty sad situation, but here are two links that help us laugh it off:
     
    Mr Trichet dances all by his lonesome:
     
    The ECB dances alone in the concert of nations:
     
     
     


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

    Additional disclosure: Long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Grece 2 Y and 10 Y bonds, Thaler's Corner.
    May 05 3:18 AM | Link | Comment!
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