The ECB is printing money. It may not yet be directly purchasing sovereign bonds but it is acting as prime broker to the following hedge funds: commercial banks in Italy, Spain, France, Germany, etc etc.

On Dec 14, 2011 it became clear what the ECB’s intentions were. Faced with political constraints and bureaucracy regarding its mandate, a desperately practical ECB decided on a course of action to operate debt monetization on a significant scale circumventing the German government’s envisaged objections. For the full analysis of the ECB’s cunning plan, refer to The ECB is Ready For QE.

To reiterate, the 3 year repo achieves the following:

• Recapitalizes the banks.
• Puts a cap on sovereign yields.
• Supports the coming bond auctions.
• Disengages the cross border holdings of sovereign bonds within the Eurozone.
• Liquefies the money and capital markets.

Is this a good thing? Well, it will create a rally in European equities and bonds. It will cause low quality banks to outperform high quality banks. It will devalue the Euro, which is good for exports, and Europe is a massive link in global trade chains. But it debases the Euro big time. This means that gold and other real assets will rise in Euro terms.

Initially, given the average intelligence of the recreational FX investor, the Euro will rise, so watch out for the volatility.

There is a reason I call this Ten Seconds Into The Future. The chances of getting a forecast right on the economy are probably 50-60% if you’re good. The chances of translating that into a call on market direction are probably 45-55% if you’re good. So whenever I express an opinion, I’m setting myself up to be wrong. But everyone needs a hobby. So for 2012, here goes.

1. There will be no new crises or nasty surprises, but there are still lots of old ones.
2. The US economy will continue to consolidate its recovery. Unless China derails it.
3. The Chinese economy will continue to slowdown. There is a high chance that it accelerates into a hard landing.
4. Europe is clearly in a recession.
5. India is in a serious funk. Unless it can restart its export economy things can deteriorate even faster.
6. Latin America is likely to recover from its current slowdown on the back of a recovery in certain natural resource markets.
7. Australia is likely to get away with another resource driven recovery.

What are the implications for markets? This is much more difficult to formulate and much more difficult to get right.

1. US exporters are likely to suffer. US domestics are likely to prosper. This follows from (2) above. As the S&P500 is replete with companies with external exposure, the broad index is likely to suffer even if individual sectors and stocks prosper.
2. Asian exporters are likely to prosper. Asian domestics are likely to suffer. This follows from (2) and (3) above. As most large listed companies are exporters Asian stock indices are likely to rise, despite a weaker Asian economy.
3. European stocks are likely to suffer given their a) there large export exposure, b) the insolvency of their banking system, c) the inability of their political leaders to agree a long term or indeed short term solution for supporting their currency system and banking system. However, the ECB is now in QE(Stealth). QE(S) began 21 Dec 2011 with 489 billion EUR in 3 year repo funding. A second tranche is prepped for 28 Feb 2012.
4. China’s role in the world economy is more important than its relative size. The Chinese economy is growing fast but its not anywhere near the size of the US economy. That said, it plays a unique part in the global scheme of things. The current strength in the US economy originates from a revival in ‘exports’ and manufacturing. Exports are in parentheses since they are strictly not exports but the production by US companies operating abroad. The most important export markets in the current context are North and Latin America. The most important exports are capital goods. The final link in the chain is North and Latin American exports of resources to China. So (6) and (7) above rely on China growing its economy through a continuation of infrastructure investment.
5. We see evidence of a slowing Europe ((4) above) in German GDP numbers, so that even Europe’s main engine of growth is spluttering. The German economy exports directly to China. A weak German number is a red flag not on Germany (the signal is to late) but on China. Europe is also weak for other reasons, the main one being a now dysfunctional banking system and money market. No amount of printing by the ECB can solve a fundamental flaw in the Euro system. It can delay the consequences for a significant amount of time but in the end printing money and expanding credit to solve a debt problem is like putting out a fire with gasoline. A loss of confidence is always the root cause of hyperinflation. Until then, expect to see tighter spreads of European sovereigns than you would normally expect when the government is bankrupt. An interesting play on this is to invest via the European banks which will no doubt be parking their cash, apart from with the ECB, in their domestic sovereign’s quite worthless IOUs. And for this folly they will earn a spread, accumulate some capital and play a part in a less chaotic disintegration of the Euro if it happens down the road.
6. (E) above tells us that the Euro must weaken against gold and very likely against the USD even more than it has this past quarter.
7. (2) above argues for continued USD strength.
8. (1) above diminishes the probability of another round of US QE. Short rates are stuck at zero as the Fed tries to get some inflation going. The yield curve may start to steepen once Operation Twist is exhausted although it is likely that the banking system may be co-opted to keep it flat. The US still needs low long term rates to get the house owner back to positive equity and positive gearing. Refinancing at current levels of interest rates, if they were achievable, would unlock significant purchasing power for discretionary spending.
9. Some of the weakness in commodities is due to the dearth of commodity trade finance so there will be a coincident recovery to do with the capital positions of the European banks.
10. There is an interesting trade in European banks. Spanish and Italian banks are under a shorting ban because investors would like to short them. The natural trade for such investors is to buy puts. If one is of the contrarian view that the 3 year repo is a de facto bailout recapitalization of the European banks, one must prefer Spanish, Italian and French banks to German banks. The trade therefore involves going short the cash stock of German and creating synthetic long futures in Spanish, Italian and French banks through their options (selling the expensive put and buying the cheap call.)

If all this sounds rather benign or even bullish, then you misunderstand. All the above is relative to a nominal or fiat currency benchmark. In 2012, given that no one in their right mind would lend to either of Europe, the US or Japan, the Bank of England, Bank of Japan, ECB and the Fed will be printing warehouse loads of funny money for the sole purpose of lending it back to their governments’.

I eagerly await each day as it unfolds the continuing story of how too much debt was created in the past few decades and where we are going to hide it next. If you can identify the flow of capital and assets, this could go quite well for you. If you’re not even looking, then it is certainly no more than a game of chance.

Good luck. We all need a little bit.

So far most commentary about a possible break up of the Euro has focused on an instantaneous exit by a single country. Their expectation that it would inevitably be very damaging leading to extended bank holidays, highly probable defaults, bank runs, and capital flight are not incorrect. However, what they may have missed is that the Euro was not created in a day, and a country need not exit the Euro in a day.

The members of the European Monetary Union had a decade since the Maastrict Treaty to get their finances in order and to stabilize their currencies against one another and the ECU, a notional accounting currency, before the introduction of the Euro on 1 Jan 1999. Three years later Euro notes and coins were issued.

The logical step at this time is to prepare for a potential break up of the Euro.

Reduce external debt. This can be done if there are backstop buyers of European sovereign bonds. Apart from the ECB the only natural candidates are the European banks. It seems counterintuitive but European banks need not just to deleverage their balance sheets, they need to avoid currency mismatches in the event of a disintegration of the Euro. This means that European banks have to buy their own nation’s debt.

Banks need to have sufficient capital to instill some level of confidence. At the moment it is hard to see any buyer in sight save for some rather broke sovereigns. Alternatively there are retained earnings but where could this come from? Perhaps from a levered carry trade on the respective sovereign bonds.

A phased exit beginning with, for example, a pegged Drachma and Lira. The peg, to the Euro, could be established for a year after which there would be a managed float to keep the currencies within defined bands of the Euro. This would in effect be a reversal of the ECU mechanism. It would provide time for legal, logistical and commercial contracts and issues to be novated from the Euro to the local currencies. No amount of time can sort out political issues.

For the first time in its history the ECB is extending 3 year collateralized funding at 1% to European banks.

The take up for shorter term funding in this time of money market stress has been strong with some 197 banks borrowing 292 billion EUR over one week. The one month tender declined as the 3 year tender opens December 21. Forecasts for the take up of the 3 year tender range from 20 billion to 250 billion EUR. The take up is likely to be at the top end of forecasts or exceed it.

• Banks need stable funding. The 3 year tender provides them 3 year money with a 12 month break.
• Sovereigns need a backstop buyer for their bonds. European banks will be vessels of the ECB as it assumes the role of lender of last resort.
• Some sovereigns are still AAA or AA and carry a zero risk weight under Basel III. Banks are thus able to fund themselves at the ECB refi rate of 1% and lend at 1.5% to 3% to France, or at 5% to Italy or Spain.
• Banks are likely to purchase their own country’s debt instead of other countries’ debt. This is to mitigate the risk of a disintegration of the Euro. This will also reduce the intra Euro area cross border holdings of sovereign debt which will make a potential break up of the Euro less damaging. A cynic might suspect the ECB of envisaging and encouraging such an eventuality.
• The ECB will be able under this mechanism to operate debt monetization without explicitly buying sovereign debt. This will circumvent any legal or treaty issues which have confounded previous plans.
• Additionally this has the effect of recapitalizing the European banking system without equity dilution. Retained earnings count as capital.

And thus debt which was once transferred and transformed from private to government balance sheets may be transferred once again to private balance sheets with a little help from the ECB.

The behaviour of markets this year has confounded expectations. It is useful to step back and view the landscape from a high level as daily market monitoring can lead to myopia and inability to distinguish between noise and signal. It is also useful to avoid over reliance on established or sophisticated financial or economic models particularly when a simple one will suffice. To understand the present it is necessary to understand the past. It is hoped that with this we might have some idea what the future might look like.

The crisis of 2008 while manifesting itself in the space of 6 months was the culmination of a much longer term phenomenon. For reasons dealt with elsewhere, debt, both public and private, was allowed to accumulate to levels which were no longer sustainable. It is not clear when the point of unsustainability was reached, but this problem began to be discovered by the market in mid 2007 accelerating to panic by the end of 2008. It was the reaction of investors attempting to shed direct or indirect exposure to this unpayable debt that led to acute market volatility and the demise of Bear Stearns, Merrill Lynch, AIG, Lehman Brothers and Northern Rock among others.

In order to maintain the functioning of the financial system, the payments system and the nexus between savings and investment, regulators and governments in their wisdom chose to bail out the system. To restore confidence, it was necessary to transform and transfer this unpayable quantum of debt from private to public balance sheets to signal adequate support for these assets or to remove them from scrutiny and analysis.

Debt can be reduced in a finite number of ways. It can be paid down, reorganized or defaulted upon. Given the size of debt in the global economy none of these was a viable short term option. It was necessary therefore to transfer such debt from institutions with credit risk to institutions where credit risk was academic, mostly arising from their ability to print money to satisfy their liabilities. Sovereign balance sheets.

One flaw in this strategy is where a sovereign is unable or unwilling to monetize debt, such as the Eurozone where monetary policy has been abdicated to a common central bank over which no single country in the union has unilateral or arbitrary control. The symptoms are plain to see.

All other central banks will likely continue to monetize the debt that their governments have assumed on behalf of credit risky holders. Even so, even the US has faced a credit rating downgrade. New and more creative ways of transforming and transferring the massive stock of debt needs to be found. Time can be bought if current holders of debt repackage the debt so as to assume first loss risk while seeking less indebted investors to provide senior funding. The devil is in the details as the European Financial Stability Facility’s initial plan to do this was rebuffed by potential senior funding providers.

The prosperity of this planet in the last few decades has been financed by debt. The calculation of GDP does not account for debt creation and therefore includes future output. This is an error. Be that as it may it is an accounting standard that our species has generally accepted. By this metric therefore, since the world collectively seeks to reduce its debt, global GDP growth must slow down and depending on the rate of debt reduction, may be negative. This result holds for the closed system as a whole.

Failure to recognize this or indeed a stark recognition of this will likely lead individual regions or nations to attempt to grow their economies at prior rates regardless. If the world’s total debt is to be reduced, debt must be redistributed and locally somewhere, it must increase. A case in point is China’s attempt to maintain growth while its single channel of growth, exports, collapsed in the wake of a severe dearth of trade finance and retrenching US consumers, which resulted in substantial credit creation. Beggar thy neighbour policies are likely to rise. Incipient signs of this are unilateral currency interventions by the Swiss National Bank and the Bank of Japan and the exchange of rhetoric between the US and China over the value of the RMB. Periods of slow economic growth or contraction can be contentious ones. As domestic demand slows and government finances are burdened by excessive debt the natural tendency is to attempt to export. Not all countries in a closed system can have a net positive trade balance. The likelihood of contentious and hostile trade policies is elevated. Currencies are likely to be co-opted as instruments of trade mercantilism.

The large scale transformation and transfer of debt or credit risk can potentially be contentious as well. During the third comprehensive plan for the Eurozone where a haircut of 50% was proposed on Greek sovereign debt, ISDA regarded this as a voluntary exchange and therefore not a credit event. This has raised questions as to the probity of ISDA. Consider also a situation where defaults in one region impact that region’s banks but where these banks have transferred their credit risk to another region through the use of credit default swaps triggering contagion. How willing will the authorities of one region be in providing relief directly or indirectly to another region at a time when fiscal austerity looms over most developed nations’ public finances?

A less apparent theme is the failure of the principal-agent relationship. This relationship is never perfect and its imperfections typically come under scrutiny in recessions. The last time this was examined was in the 2001 Dotcom bubble where stock options rewarded management for success without appropriate penalties for failure. There is a wider manifestation of this problem. The most visible is in the banking system, especially because they required bailouts paid for from public funds. Banks serve several functions, among which are safe custody of depositors’ assets, and a safe and efficient transmission between savings and investment. As management remuneration is asymmetrical, it is possible to earn a positive bonus but not a negative one, excessive risk taking and cavalier stewardship arose which culminated in the financial crisis of 2008. As a result the trust has been broken between banks and depositors.

A similar lack of trust has arisen between people and their governments. The troubles in Middle East North Africa which began earlier this year have not abated. Even in democratic and apparently democratic regimes, election results are equivocal and represent a lack of clear mandate to any government. Governments are agents to their people who are the principals. As stewards of their welfare the rise of income and wealth inequality is an indictment of their performance. Gini coefficients have risen in Communist, Socialist and Capitalist countries alike. High rates of inflation in the developing world are potentially destabilizing and investors may underestimate the priority of price stability in agrarian societies. Debt monetization is fundamentally inflationary adding to the complexity of policy that faces governments.

There is no new crisis, only the ripples and aftershocks of the first one in 2008. Time is what is required for the global economy to heal itself. Patience unfortunately is lacking. The result may be interim solutions which defer inefficiencies and imbalances but do not dissipate or address them. Unfortunately, for me, I have no answers and am only an observer in these dramatic proceedings.