Big Picture Thinking: The Euro, Greece, Europe, ECB

Currency in Crisis

There have been a number of developments in Europe over the past several days and the euro has broken down. Its nine cent decline in nine days demands attention. The 5 and 20 day moving average have generated bearish technical signals, led by sterling, followed by the euro, and confirmed by the Swiss franc. Other bearish technical developments have taken place.

The euro broke below its 50 day moving average for the first time since mid-January, came back to test it before the weekend and failed. The euro posted an outside down day on Friday the thirteenth as did the Swiss franc. Sterling staged its own reversal in the middle of last week when the market assumed the downward revision to the Bank of England's growth forecast and upward revision to inflation forecasts meant a rate hike would be forthcoming. The next key chart points are found in the $.139-$1.40 area for the euro and $1.60 for sterling.

Rate Differentials: I have been consistently explaining the moves in the euro as largely a function of the divergent trajectories of monetary policy, which is interrupted from time to time by a flare up of European tensions. The price action of the euro, to me, is very important over the next couple of days. The rate differential widened during the second half of last week and the euro made new lows for the move. If the euro does not recover soon, it could very well be a warning sign that the risk premium for holding euros has risen and that this is not simply a position squaring adjustment. This is supported by the options markets insofar as the risk/reversals favor euro puts by essentially the most (~2%) since mid-Jan when the euro's rally began in earnest.

Greece: The recent unscheduled European meeting was important in that key officials acknowledged that Greece's situation was not resolved. Two-more years of financial support is about 60 bln euros, it is reckoned on the basis of maturing bonds, but more needs to be thrown in cover budget deficits (and not as well and increased costs for debt servicing. My sense after trying to make sense of the cacophony of official-speak is that on balance a new package, targets, and conditions are preferable to restructuring now or leaving monetary union, for the euro-elite.

It seems very much that the talk of Greek exit was part of the acceptance that more money would be needed. Policy analysis is ultimately policy advocacy. By analyzing the potential courses of action, the costs of the less desirable paths are projected higher and that allows (forces?) the focus on less costly paths regardless of how unpleasant it is. I am not so much interested in the terms. The more debt that is piled on to Greece and the more assets is has to sell to foreign creditors (as perhaps some of the EU conditions may require and/or transfer of its gold, the more likely the restructuring will be and the larger the haircut. The 800 pound gorilla in the room is German domestic politics and few if any are discussing it in the context of the debt crisis. It is not clear that Merkel can deliver the Bundestag to support more aid to Greece. The government enjoys a 20 seat majority, but the local press reports 19 defects, though the vote probably will not be held for several months, and that is with the opposition supporting the Merkel’s aid request. Writing a small check now is preferable to a big one now. That a big check may have to be written in the future is a different issue and one that will not be addressed now.

CDS: I remain suspicious of the CDS market for sovereign bonds. People trying to decipher the pricing have of course developed models and these fair value models suggesting that there is about a 75% of a haircut in the middle of the S&P recovery rate range (30-50%) priced in. I think this makes the bonds more attractive than they really are.

First, I do not know how liquid that market is and who is selling the CDS on Greece, so in terms of price discovery, I am not convinced. Second, my less sophisticated and pre-financial engineering tool of simply looking at the spreads over risk-free assets, warns that Greek bonds can sell off much more relative to the risk free asset, for which I have been using bunds, but they are not immune from a risk-premium itself. Third, given the linkages between the sovereign and the banks, some fund managers may use the CDS market to protect other exposures. In any event, over the past two weeks, the price of 5 year CDS on Greece fell by around 10%. The 10-year interest rate differential has been stable over the same period.

ECB President: Next week the formal selection process of the next ECB president begins. Names will be put forward. The only name will certainly be put forward is Draghi, Italy's central banker. Since Weber took himself out of the game, he has been the favorite. I personally thought three things would have blocked his candidacy: 1) his years at an investment house during the period in which European countries bought derivatives that help them conceal their debt, 2) there is a southern vice president (Portugal), which Merkel had helped arrange to grease the skids for Weber, and 3) Italy itself has debt problems.

Weber's departure caught Merkel wrong-footed and she has not been able to recover. Sarkozy's endorsement of Draghi gave her an opportunity to minimize the loss by seeking a concession for her acquiescence. It looks like Merkel's coalition partners, the FDP, are more hostile toward Draghi and the concession they seem to be pushing for is some measures that would increasing the independence of the ECB.

Here Italian politics could be more telling. Assuming that Draghi replaces Trichet, it would leave no representative from the euro zone’s second largest economy France. In the European-style of politics, pressure would be brought to bear on Italy’s other board representative Bini-Smaghi. With the bounded rationality, Italy could name Bini-Smaghi as Draghi’s replacement as governor of the Bank of Italy. However, Italian finance minister and a potential successor to Berlusconi has a different candidate in mind, like Bini-Smaghi, highly respected and competent Vittorio Grilli, who oversaw large scale privatization efforts.

Sovereign Debt: The media and many other observers continue to emphasize the sovereign aspect to the debt crisis. To do so is to accept the German and ECB narrative. But when thinking through the issue from investors point of view it is not so much a sovereign crisis as a bank crisis. German banks have more exposure to Greek banks than they do to the Greek government.

If there is a 50% haircut on Greece's sovereign some foreign banks will take a hit but it will not be a crisis, but Greek banks will be wiped out for all practical purposes and that is what will hurt foreign banks.

The ECB would also take a hit. Of the roughly 75 bln euros of bonds the ECB has bought, it seem fair to assume that around 2/3 would be Greek bonds or 50 bln euros. Even though the bonds were bought at a discount, a sovereign hair cut would still hurt. On top of that the ECB has lent Greek banks about 95 bln euros. Of course there is collateral for that, but its value is likely to be, say impaired, if the sovereign doles out a haircut and Greek bank capital is wiped out.

BIS data suggests that foreign exposure to the sovereigns of Greece, Ireland, and Portugal is about $266 bln. This is about half as much as foreign exposure to peripheral banks ($488 bln) and non-financial businesses ($100 bln) combined. Greece is a sovereign debt crisis. Ireland was a private debt crisis that the European elite--in Ireland and elsewhere--insisted had to be and will continue to be public debt. Portugal is also a story primarily of private that is bank debt and they accumulated it without the bubble that Ireland, the UK or Spain had.