Tortoise, Hare And The Coalition Of The Unwilling

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Includes: FXE, UDN, UUP
by: Douglas Borthwick

Comments out of the Bundesbank are disheartening to my view that the IMF will act like a lender of last resort to European Sovereigns in regard to their refunding needs. I have held the view that the IMF will set up an unprecedented separate European "Trust" into which individual countries would contribute via their National Central Banks. This Trust would be administered by the IMF; offering funding to European Sovereigns that would need it because market prices would be too prohibitive. Comments from the Bundesbank suggest that this Trust is not being created, given the Bundesbank stated it would be contributing to the IMF's general fund if it was asked to by the IMF.

My most recent central thesis has been that European Sovereigns would be given the choice of borrowing from the market or from the IMF. If they went along with austerity measures as suggested by the EU, then market yields would drop as the market rewarded them for their austerity. If they failed to follow the EU guidelines, then they would be priced out of the market funding, and would be forced to borrow from the IMF, where the IMF would then force them to take austerity actions. Either way, European Sovereigns would be forced to keep to the path of balance sheet restructuring necessary for European Fiscal Union.

The IMF has yet to announce the nature of European Funding, and last week, Lagarde stated that it would take her 10 days to finalize her plan. Comments out of China, Japan and South Korea suggest they too are waiting to see the plan before making a decisive contribution. Currently the IMF plan is looking like a coalition of the unwilling. This makes sense given there is no flesh on her proposal. It could be that the Bundesbank stated they would offer bilateral accommodations to the general fund because a Trust has not yet been announced. We will find out next week.

The Tortoise and the Hare

We are all aware of the story of the Tortoise and the Hare. In the global macro space I see Europe as the Tortoise and the United States as the Hare. Unfortunately for Europe, in the short-term, the market rewards Hares rather than Tortoises. Europe is taking its time in enacting reforms because of treaty-change complexity. However I do believe that Europe is trying to deal with the root cause of the European debt crisis; seeking to reduce the European debt load and restructure economies away from the public sector and into the private sector. This restructuring is going to take time, more time than the market is willing to offer. The United States on the other hand is failing to deal with the root cause of U.S. weakness, instead papering it over with quantitative easing. This is a short term fix that while offering results today will have a reckoning at some time in the future.

While Europe is willing to accept lower GDP in the coming quarters in order to achieve a more sustainable debt load, the United States is willing to increase its debt load to achieve higher GDP. This path is resulting in a weaker EUR/USD in the short term. However I believe in the long term this strategy will be negative for the U.S. dollar. Headwinds remain on the downside for the EUR/USD from Middle Eastern and Asian Reserve Managers. We are also likely to see significant short-squeezes in the EUR/USD in the near term given market positioning. However without the IMF creating a Trust for the use of only European Sovereigns I fear that the market will reward the Hare over the Tortoise.

Without creating a Trust within the IMF for Europe, any contributions into the general fund are likely to be under the watchful eye of the U.S. Congress, and while the U.S. has little interest in seeing a stronger U.S dollar - which would come as a result of the U.S. blocking any European bailout - the U.S. election season is likely to play a role in the decision-making. Congress is likely to block any funding from the general fund for Europe under the guise of "why should the U.S. taxpayer bail-out Europe?" Well, the U.S. taxpayer should bail-out Europe because if they do not, then the U.S. will be priced out of world markets due to the strength of the U.S. dollar that will result from inaction. In addition the U.S. economy will be greatly affected by any severe recession in Europe.

If the IMF announces next week that they are creating a separate Trust, or European Monetary Fund, separate from the general fund, then the U.S. Congress will not have a say over how the monies are distributed. European economies will be forced by the market and the IMF to restructure their economies. The EFSF will likely provide funds to European Sovereigns to help them restructure their banks, and the ESM will likely help provide liquidity in the secondary market by purchasing the sovereign debt of countries that are following the plan, and letting the market drive yields higher for those that are not changing fast enough.

Merkel and Sarkozy are well aware of the need to cajole governments into action. It is for this reason that the independent ECB stands so vehemently against decisive buying of European sovereign debt in the secondary market. Its much easier to force Italy or Spain to act when yields are higher than when they are at 3.5%. They need the motivation, and secondary yields provide that handily.

One plus for the ECB is that it can be political. The Fed cannot because of its dual mandate. The Fed will be forced to QE for as long as Congress fails to address fiscal issues. The Fed has no stick, only carrots, and so there is no incentive for Congress to stop and indeed cut back spending. For this reason alone I see the EUR/USD higher in the long term. There is much riding on Lagarde's decision on the structural nature of any European debt solution. If it is part of the general fund, then the EUR/USD is likely to see further weakness going forward, moderated somewhat by further quantitative easing from the U.S. Fed, as it will seek to slow further USD strength which would result in lower U.S. equity markets.

The Tortoise needs the IMF to come out with a separate Trust. Without it the Hare will win over the short-term.

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