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Joseph Stuber
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Joseph has been an analyst, investor, and student of economic theory; money and banking; and statistical methods for evaluating and implementing risk/reward trading algorithms since 1972. Joseph is also an occasional contributor to financial publications and his essays are frequently cited by... More
  • Cyprus Parliament Calls The EU's Bluff But The EU Wasn't Bluffing 6 comments
    Mar 21, 2013 11:42 AM

    The recent strength in the Eurodollar has added insult to injury for those Euro zone countries struggling with massive debt and high unemployment. An effective monetary policy for these countries is to devalue their currency.

    The problem is these Euro zone countries don't have a sovereign currency to devalue. Furthermore, not all who use the Eurodollar have the same problem and therefore don't have a vested interest in currency value destruction. Bottom line - the situation is an intolerable mess.

    Mario Draghi has uttered a few guarded statements suggesting that he is concerned about the strength of the Euro in recent weeks. For that matter, IMF head Christine LaGarde has made similar comments. The problem - the ECB doesn't have the tools to devalue the Euro.

    That said, where there is a will there is a way. Want to take the Eurodollar down - just start confiscating depositor funds. Despite what many think, the convoluted mess created by the decision to seize depositor funds to rescue the Cyprus banks might not be as ill conceived as most assume. In fact, I don't think it was ill conceived at all. I think it was a calculated decision taken for the purpose of devaluing the Eurodollar and Cyprus was the sacrificial lamb.

    The euro has been a colossal failure and for good reason. How do you merge a group of hard core socialist countries and a group of hard core capitalist countries under a single monetary system that has no real power and expect it to succeed?

    I don't profess to be an expert but as an observer it seems to me that the "have not's" expect the "haves" to come to the rescue and the "have's" insist that the "have not's" adopt the methods that got the "have's" what they have if they expect to be rescued.

    Doesn't that about size the situation up adequately and how should we expect these diametrically opposed philosophies to co-exist under one monetary umbrella? The tug and pull of this dynamic has gone on for some time now and the situation has moved from bad to worse. At some point the "haves" must simply say no more to protect their own interests.

    The problem though is keeping the union together. The simple truth is that a one size fits all monetary policy can't work when the philosophical differences create such a wide divide. Actually, this situation extends beyond the Euro zone as the one world economy we live in today is almost as ineffective from a monetary policy perspective on a global basis as the Euro zone's convoluted monetary system is but that subject must be left for another time.

    Back in October I commented on the state of the economic:

    What has occurred in the US and across the globe over the last few decades is a policy of easy money. We have mortgaged ourselves to the hilt relying on inflation to provide the necessary security for these overleveraged debts.

    We know the state of things in the Euro zone. The 'haves' - led by Angela Merkel and the Germans - are forcing the 'have not's' to deal with deficit spending. It will be painful and economic contraction will certainly occur but it is the only alternative that promises an eventual end to the mess we find ourselves in today.

    The comments above pretty much sum things up from my perspective. We are in a huge mess and on a global scale and no monetary system currently in place works to deal with the interconnected economies that posses such divergent philosophies.

    Although we have never been in quite the predicament on a global scale that we find ourselves in today the closest we can come too in terms of comparison is the post WWII era where economies had became severely overleveraged as a result of financing a major world war. The Bretton Woods system was the solution but it too had flaws.

    Specifically, the US Dollar backed by gold was assigned as the global reserve currency but that arrangement fell apart in large part due to the fact that a sovereign nation's currency was established as a reserve currency. The problem was noted early on by Keynes and more fully explained by Robert Triffin whose views on the matter are referred to as the "Triffin dilemma".

    The problem was simple - a sovereign nation - in order to effectively control the domestic economy must implement monetary policy that incorporates a modest inflationary trend to assure growing GDP and thereby full employment. Over the years the US did just that to assist the domestic economy but in so doing undermined the US Dollar as far as its status as a reserve currency.

    In other words the money supply expansion meant that the US didn't have sufficient gold reserves to redeem dollars in gold. In 1971 the US government terminated convertibility of the US Dollar to gold effectively ending the Bretton Wood's system.

    The truth is that "muddling along" is a severe understatement as far as global economies are concerned today. Each of the major economies has their own particular problems. Japan has the lost decade's syndrome precipitated by a multi decade attempt to devalue through monetary expansion and debt.

    The US is stuck in a conundrum where attempts to devalue and inflate out of the problem have been thwarted by the US status as the world's reserve currency. The US is also stuck in a liquidity trap as cash hoarding since the Great Recession has worked to defuse the impact of monetary and fiscal policy.

    China's desire to grow GDP at all costs has created high rates of inflation. Without doubt the biggest problem of all though is in the Euro zone countries. How does one compete in a global economy where every major economy fights to devalue except one - the Euro zone?

    So, this brings us to Cyprus - the sacrificial lamb. The very idea that the Troika would demand that depositors absorb a portion of the banks bail out costs seems offensive to most but there is a risk associated with depositing money in a commercial bank. After all, we do have deposit insurance to protect against that risk don't we?

    The guarantee that you can have your money when you want is only as good as the bank making the guarantee. If they take your deposits and invest them in ways that put those deposits at risk the first back stop is the banks own capital but if the losses are large enough the banks capital becomes inadequate requiring a bail out or bankruptcy.

    I personally don't have a problem with a rule or law that is fairly applied but I don't care much for selective application of the rules and that is what we have with Cyprus. I see it for what it is - an attempt to set the tone going forward and to simultaneously devalue the Eurodollar. Both are necessary but the fact that the Troika picked the smallest of all possible targets to employ this tactic does seem immoral.

    Notwithstanding the truth of that observation, it was done with very specific intentions. Can one really see it any other way? We are talking $6 billion euro's after all - a pittance in the scheme of things -- and the immoral and selective application seems designed to achieve an end. The first is to use Cyprus as an example of what will happen to you if you don't tow the line and the second is to devalue the Eurodollar. One certainly can't say the magnitude of the problem was so massive that it couldn't be solved and solved with ease.

    As much as I hate to say this I think the end may justify the means as the Euro zone is in desperate need of attacking their problems on two fronts. First, systematic deleveraging must occur and second, the Eurodollar must be brought down. The risk is that the solution could end up destroying the Euro zone and the Eurodollar but that too may be a risk that was calculated and accepted.

    In fact, it is hard for me to see it any other way. I suspect the Troika did see the possibility of contagion and a flight from the Eurodollar across the region as a real possibility.

    There are many who still don't see this move as a major global threat. I suggest you might be wrong. The Troika has made a very deliberate statement here and they are not bluffing. Immediately after the announcement that the Cyprus government had rejected the plan the ECB began plans to assist in the liquidation of the banks. Here are some of the headlines on my Forex news feed:
     

    • Bank resolution plan being developed in case of bank run.
    • Control plans could be in place for weeks.
    • Plans to fly in euro notes from other countries to feed Cyprus ATM's.
    • Under capital control plans border checks for cash over certain amount would be introduced.
    • Cyprus, ECB working on capital control plans.


    The market took heart when the ECB announced they would provide liquidity within existing rules. I guess many assumed that meant the ECB immediately buckled and that the Cyprus banks would be bailed out after all as the stock market surged immediately after the announcement.

    That is not what the ECB intends nor is it what their statement implied. If the banks are shut down the ECB will provide liquidity but that doesn't mean bail out -- it means the ECB will assist the banks in getting cash into the system so that depositors can get to their money.

    Of course it does pose a difficult problem in that the Cyprus banks don't have that cash beyond their required and excess reserves which is likely in the range of 10% of total deposits. The rest of the cash that depositors will eventually receive is locked up in investments and those investments must be sold to convert them to cash.

    The ECB's statement means that they will move excess reserves to the various banks and nothing more - at least that is my take on the meaning of the statement. If the Cyprus Parliament thought they were calling the Troika's bluff my guess is they made a bad call.

    When the air clears Cyprus banks will be shut down and depositors will surely lose a lot more than they would have otherwise.

    The bottom line - this is probably a done deal and a really bad deal for Cyprus unless they reconsider or an angel surfaces. As far as putting downward pressure on the Eurodollar is concerned, I can't see any other outcome once people fully understand the implications of this move. At one point after the announcement the German 2 year bund yield was at minus .1% yield meaning the buyer is effectively paying Germany to protect their money.

    I suspect this will become more prevalent as the reality of this mess sinks in. A flight out of Eurodollars and into safe haven's such as the German and US bond market will work to put significant downside pressure on the Eurodollar and push bond prices and the US dollar higher. That will work to put downside pressure on equities as well - in part from the strong dollar and in part from the economic impact arising from a flight from the Eurodollar and the possibility of an EU break-up.

    Disclosure: I am long FAZ, TZA, TECS, UVXY.

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Comments (6)
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  • Valueplay98
    , contributor
    Comments (580) | Send Message
     
    What do you think happens if Cypress leaves the EU ?

     

    With Monday's deadline looming ... who'd want to be long on Friday ?

     

    I can't see any good resolution to the Cypress mess that doesn't weaken the Euro ~
    21 Mar 2013, 02:15 PM Reply Like
  • Joseph Stuber
    , contributor
    Comments (1700) | Send Message
     
    Author’s reply » "With Monday's deadline looming ... who'd want to be long on Friday ?"

     

    Who'd want to be long right now? Not predicting it but this is setting up for a real flash crash.

     

    The algos are confused. You have the dip buy algos and the euro and yen algos. Then you have the Swiss defending against the euro and maybe others and you have short sellers on the euro - who knows who - probably everybody but the central banks.

     

    Pimco came out saying they were lowering their exposure and Blackrock sort of walked back yesterdays statement about Cyprus.

     

    All the while the retail trade is totally oblivious to the implications. Low volume - not to worry mind set is still in play on the retail side.

     

    If I held euros I would be moving them into anything else and probably buying bonds US/German. Downside pressure on the euro could become overwhelming if a mass exodus starts. Probably won't but I am not saying it can't happen. You could also see one hell of a short squeeze on VIX futures.

     

    Going to be an interesting few days going into next week.

     

    JS
    21 Mar 2013, 02:50 PM Reply Like
  • Valueplay98
    , contributor
    Comments (580) | Send Message
     
    Retail trade oblivious ? How about the big boys ? I guess they're hedged better, but then go look at 2008-2009 returns...

     

    With HFT running the show and Ben's foot on the pedal we can't even get a 1% down day ... VIX still under 14 ?

     

    I think it's going to get very ugly when it goes.
    21 Mar 2013, 03:35 PM Reply Like
  • tampat
    , contributor
    Comments (995) | Send Message
     
    JS,

     

    Curious why aren't you short the Euro?
    EUO maybe?
    21 Mar 2013, 04:38 PM Reply Like
  • Joseph Stuber
    , contributor
    Comments (1700) | Send Message
     
    Author’s reply » tampat

     

    I just think there are better ways to play the trade if the euro does what I think it will do. I think short euro or long dollar is a great trade.

     

    JS
    21 Mar 2013, 05:22 PM Reply Like
  • paulmichael
    , contributor
    Comments (155) | Send Message
     
    This is what the elite want and have planned... they know this move will cause people to drain accounts worldwide, which will lead to market collapse and war. It is part of the protocols of one world government. Next we will see armies in the east preparing to attack Israel, in defense of middle east oil countries, so vital to Asian economies. Then a general will rise in Japan and robot armies will be deployed in the entire earth. The mark of the beast (microchip implant) will follow, Bibles will be banned, and antichrist will reign for a time. The Lord is coming, look up!
    24 Mar 2013, 02:04 PM Reply Like
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