Welcome Back, We Hardly Missed 'Ya

Includes: EWG, EWL, FXE, FXF, VGK
by: Alhambra Investment Partners

By Jeffrey P. Snider

It may have been something like two years, maybe closer to 18 months, but it seems just like yesterday that Europe had left its deficient construct in the past. It was a daily ritual back then, exercising due diligence often through nothing more than checking just how negative bond rates would spring. There were German bunds and even indications of Danish favorability, but it was the Swiss where the currency crisis was most evident. The Swiss government bond curve was like something out of a child's drawing, nothing resembling a curve at all, but rather negative deposit rates up to three months, a sudden bout of plus numbers out to a year, then a sharp triangle diving deep down centered around, for reasons not related to general "markets," the 2-year maturity.

When visiting the Swiss rates again this morning, that old familiar feeling was so easily incorporated that the time that has passed between is but an instant in the observance of European monetary plumbing. While in the "right" frame of mind this should all be far more melancholy than melodic, there it was, the Swiss curve taking on that irregular "line" that used to so easily file itself under the headline "fear."

Forgive my overly dramatic and self-serving style, but there is something very confirming about the return of Europe's devastating irregularities, and I don't mean just that nothing was ever really done about their massive imbalances. History is cyclical, not linear, which is why extrapolations are universally ineffective. The only way to move the cycle from one to the next is genuine reform - otherwise, as some wise man once interjected, repetition will be the curse.

While the Swiss 2-year "triangle" has returned, that is not to say that it is totally conforming to close-by memories of 2012. The "zeroness" of its "curve" now extends to the four-year mark, with maturities by year going, starting at the 1-year, +0.05%, -0.39%, +0.009%, +0.002% and +0.066%. Germany, not to be totally outdone, has a yield zeroness all the way out to three years, with everything shorter within a few bps of negative. That would suggest, not wholly unlike US flattening, elongating concerns about growth, economy and finance.

What was always so striking about the Swiss "market" was just how regular and smooth the interest rate swap curve was in relation to the jaggedness of the cash market. In fairness here, that really isn't anything new or returned, as this difference has endured through the ebbs and flows (and now ebbs again), but I think it speaks as much about the differences between what and how policy measures can actually impact these places. The swap curve is as much the SNB as the government bond curve is ledger "money" in banking conducting cross border transactions (in either direction).

From that you can get a sense for how policy might make things look like - they are moving in the right direction, and in some sense may actually be, but that is not the same as the problem never occurring in the first place. In other words, you, as a central banker, can attempt to reroute "harmful" flow but that is something altogether different, though you pretend the opposite, as never experiencing that flow. Because of that seemingly subtle difference, there are always collateral effects, unintended as "always," to consider.

We have no way of knowing, of course, whether this is just a temporary adjustment and undying faith in ECB promises will once again retain their prior "currency" with deep market participants, but taking the dangerous path of extrapolation you cannot help but wonder about the implications more broadly. Even if there is no revisit to the desperate currency worries of just a few years ago, there are enough negative indications to at least undertake something of the idea in perhaps shorter proportions.

Gold prices, for example, which are my primary concern in all of this intentional verbosity, have been strangely attracted to $1,300 as if by way of the supernatural. That might be the interpretation had not other very conspicuous markets done very nearly the same over the exact same period. This despite two very heavy and negative price pressures; namely collateral concerns in other funding markets and the persistent and rising drone of golden "death" pronouncements.

It is hard to find another market so hated by the mainstream, evidenced in nothing short of full confirmation by the glee at which 2013's price behavior was "reported." Nothing so strongly rebukes the mainstream economic and monetary orthodoxy quite like rising gold. And that is the relation that Europe's recent return to the "unknown" column evinces. After all, gold's rapid ascent in 2010 and 2011 contained far more than a little euro flavor. The greatest need for extreme "tail risk" insurance would be a major currency, a semi-reserve currency, calamity.

The usual caveats need to be reaffirmed, in that almost everything with gold is beneath the surface, described only minimally by second hand indications and inference. I already speculated, meekly, about how the collateral issue itself may have undergone a paradigm shift of possible central bank withdrawal, and that would certainly alleviate some of the negative price pressures if valid. Any growing nervousness over the illusion of Draghi-control in Europe (and not just Europe) would be of a similar construction for gold fundamentals.

Again, while that may be a dangerous extrapolation, the all-too-familiar ring of negative and deformed bond curves in Europe is very much something to consider going forward. I have probably over-repeated the line that Europe is not in recovery, only experiencing a temporary absence of further contraction, so as that gains wider consideration you have to wonder how that will be "priced" not just in the immediate "markets" of sinking stocks (after a huge run) and bonds (likewise). Will the momentum chasers that took advantage of Draghi's enduring softness igniting what amounted to very wishful thinking stick around under far different circumstances?

I think that describes the situation as it is confronted by the ECB today with its deeper appeals to negative interest rates and "targeted" monetary measures - there is, if you look closely enough, more than a little desperation to these heightened policy levels. Some "markets" may have picked up on that, receiving only confirmation these past few weeks and months.