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Knight Capital's European Macro Notes - Why the Rally?

Tyler Durden's picture




 

From Brian Yelvington of Knight Capital

Europe:  The rally over the last few days has been driven by quite a few seemingly bullish headlines and one CDS scare.  It seems every player that has gotten active in the space over the past couple months now has no interest in being long protection.  Many of the ideas being bandied about are part of the normal process of working through such a large and difficult situation.  We maintain our belief that the ultimate solution here will be one that involves a central treasury and central fiscal framework.  Merkel’s “Pact for Competitiveness” provides a nice first step, but has no central treasury function and no real way to enforce the fiscal discipline portion of the suggestions – in short, it looks a lot like the Maastricht Criteria, but more fleshed out with respect to imbalances at the taxation and labor levels.  The markets are pricing as if Germany and France are categorically on the hook already.  Though we believe in that endgame, we do not believe the time is now for that to be priced in.  With elections in Ireland and Germany coming up within the next two months (along with a slew of debt coming due), the markets will have a chance to see what the voters think.  Democracies can make this messy. 
 
The talk regarding the EFSF having the potential to buy bonds raises more questions than answers to us.  For one, at what price will they be purchased?  Banks that hold the sov debt are reticent to sell below par since that would make them realize a loss.  The EFSF can ill afford to purchase bonds from banks at par when they are trading in the open market at prices well below that, and such a subsidy does not seem to make economic sense either.  The aforementioned voters will soon recognize that this debt purchasing is a transfer and represents taxation on core country’s citizens to support periphery debt.  Also, who might sell?  The ECB’s program has a scant €76.5B to sell into such a scheme against an aggregate periphery debt load of over €3.2T.  Direct issuance is a possibility, but then the EFSF becomes an even bigger CDO performing funding arb – at an unknown cost.  With only €440B available, it seems that the funding for only a portion of the periphery would be achieved.  Further, the AAA rating on the bond issuance out of the EFSF has a participant element to it.  If a country needs funding, it is prohibited from contributing to the facility and whatever it draws comes out of the facility.  Would a purchase of a particular country’s bonds by the facility constitute a drawdown per the facility’s rating requirements?  It would seem so, though details are sketchy right now.  Either way, this would seem to impact the ratings that were so important they took five months to obtain last year. 
 
The most fearful prognostication from the point of view of those who are negative on the peripheral situation is that restructurings could occur that would not trigger CDS.  There is no doubt this is possible, but there are more moving parts than first meet the eye.  For starters, such restructurings would have to be voluntary and not binding on all holders.  This puts the restructuring country in a game of chicken with bondholders.  If bondholders hope for a better deal and hold out, then the country has not achieved its goals.  Without Collective Action Clauses (CACs), it is going to be hard to get holders in a room and amend debt.  We do believe that most of the debt is held by EMU member banks, who might be satisfied with extension so long as they do not have to take a loss, but we note that they are likely the chief purchasers of short dated protection and thus have a bit more incentive not to see the whole CDS protection matrix suddenly become worthless.  Pols could also potentially desire an event (that settles near par) in order to shake out the speculators that they blame so heavily for the current malaise. 

 

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Tue, 02/01/2011 - 18:09 | 925350 Sudden Debt
Sudden Debt's picture

Very good point about the elections in 2 months in Germany and Ireland.

That will rock the boat to say the least.

72% of the Germans want to get rid of the Euro and back to the Mark, that will be headlines.

 

And Ireland will print... that's contained and meaningless.

 

But Belgium will also get the elections in 1 or 2 months. That will also rock the boat.

 

Tue, 02/01/2011 - 18:20 | 925397 Sudden Debt
Sudden Debt's picture
How Goldman gambled on starvation

Speculators set up a casino where the chips were the stomachs of millions. What does it say about our system that we can so casually inflict so much pain?

By now, you probably think your opinion of Goldman Sachs and its swarm of Wall Street allies has rock-bottomed at raw loathing. You’re wrong. There’s more. It turns out that the most destructive of all their recent acts has barely been discussed at all. Here’s the rest. This is the story of how some of the richest people in the world – Goldman, Deutsche Bank, the traders at Merrill Lynch, and more – have caused the starvation of some of the poorest people in the world.

It starts with an apparent mystery. At the end of 2006, food prices across the world started to rise, suddenly and stratospherically. Within a year, the price of wheat had shot up by 80 per cent, maize by 90 per cent, rice by 320 per cent. In a global jolt of hunger, 200 million people – mostly children – couldn’t afford to get food any more, and sank into malnutrition or starvation. There were riots in more than 30 countries, and at least one government was violently overthrown. Then, in spring 2008, prices just as mysteriously fell back to their previous level. Jean Ziegler, the UN Special Rapporteur on the Right to Food, calls it “a silent mass murder”, entirely due to “man-made actions.”

Earlier this year I was in Ethiopia, one of the worst-hit countries, and people there remember the food crisis as if they had been struck by a tsunami. “My children stopped growing,” a woman my age called Abiba Getaneh, told me. “I felt like battery acid had been poured into my stomach as I starved. I took my two daughters out of school and got into debt. If it had gone on much longer, I think my baby would have died.”

Most of the explanations we were given at the time have turned out to be false. It didn’t happen because supply fell: the International Grain Council says global production of wheat actually increased during that period, for example. It isn’t because demand grew either: as Professor Jayati Ghosh of the Centre for Economic Studies in New Delhi has shown, demand actually fell by 3 per cent. Other factors – like the rise of biofuels, and the spike in the oil price – made a contribution, but they aren’t enough on their own to explain such a violent shift.

To understand the biggest cause, you have to plough through some concepts that will make your head ache – but not half as much as they made the poor world’s stomachs ache.

For over a century, farmers in wealthy countries have been able to engage in a process where they protect themselves against risk. Farmer Giles can agree in January to sell his crop to a trader in August at a fixed price. If he has a great summer, he’ll lose some cash, but if there’s a lousy summer or the global price collapses, he’ll do well from the deal. When this process was tightly regulated and only companies with a direct interest in the field could get involved, it worked.

Then, through the 1990s, Goldman Sachs and others lobbied hard and the regulations were abolished. Suddenly, these contracts were turned into “derivatives” that could be bought and sold among traders who had nothing to do with agriculture. A market in “food speculation” was born.

So Farmer Giles still agrees to sell his crop in advance to a trader for £10,000. But now, that contract can be sold on to speculators, who treat the contract itself as an object of potential wealth. Goldman Sachs can buy it and sell it on for £20,000 to Deutsche Bank, who sell it on for £30,000 to Merrill Lynch – and on and on until it seems to bear almost no relationship to Farmer Giles’s crop at all.

If this seems mystifying, it is. John Lanchester, in his superb guide to the world of finance, Whoops! Why Everybody Owes Everyone and No One Can Pay, explains: “Finance, like other forms of human behaviour, underwent a change in the 20th century, a shift equivalent to the emergence of modernism in the arts – a break with common sense, a turn towards self-referentiality and abstraction and notions that couldn’t be explained in workaday English.” Poetry found its break with realism when T S Eliot wrote “The Wasteland”. Finance found its Wasteland moment in the 1970s, when it began to be dominated by complex financial instruments that even the people selling them didn’t fully understand.

So what has this got to do with the bread on Abiba’s plate? Until deregulation, the price for food was set by the forces of supply and demand for food itself. (This was already deeply imperfect: it left a billion people hungry.) But after deregulation, it was no longer just a market in food. It became, at the same time, a market in food contracts based on theoretical future crops – and the speculators drove the price through the roof.

Here’s how it happened. In 2006, financial speculators like Goldmans pulled out of the collapsing US real estate market. They reckoned food prices would stay steady or rise while the rest of the economy tanked, so they switched their funds there. Suddenly, the world’s frightened investors stampeded on to this ground.

So while the supply and demand of food stayed pretty much the same, the supply and demand for derivatives based on food massively rose – which meant the all-rolled-into-one price shot up, and the starvation began. The bubble only burst in March 2008 when the situation got so bad in the US that the speculators had to slash their spending to cover their losses back home.

When I asked Merrill Lynch’s spokesman to comment on the charge of causing mass hunger, he said: “Huh. I didn’t know about that.” He later emailed to say: “I am going to decline comment.” Deutsche Bank also refused to comment. Goldman Sachs were more detailed, saying they sold their index in early 2007 and pointing out that “serious analyses … have concluded index funds did not cause a bubble in commodity futures prices”, offering as evidence a statement by the OECD.

How do we know this is wrong? As Professor Ghosh points out, some vital crops are not traded on the futures markets, including millet, cassava, and potatoes. Their price rose a little during this period – but only a fraction as much as the ones affected by speculation. Her research shows that speculation was “the main cause” of the rise.

So it has come to this. The world’s wealthiest speculators set up a casino where the chips were the stomachs of hundreds of millions of innocent people. They gambled on increasing starvation, and won. Their Wasteland moment created a real wasteland. What does it say about our political and economic system that we can so casually inflict so much pain?

If we don’t re-regulate, it is only a matter of time before this all happens again. How many people would it kill next time? The moves to restore the pre-1990s rules on commodities trading have been stunningly sluggish. In the US, the House has passed some regulation, but there are fears that the Senate – drenched in speculator-donations – may dilute it into meaninglessness. The EU is lagging far behind even this, while in Britain, where most of this “trade” takes place, advocacy groups are worried that David Cameron’s government will block reform entirely to please his own friends and donors in the City.

Only one force can stop another speculation-starvation-bubble. The decent people in developed countries need to shout louder than the lobbyists from Goldman Sachs. The World Development Movement is launching a week of pressure this summer as crucial decisions on this are taken: text WDM to 82055 to find out what you can do.

The last time I spoke to her, Abiba said: “We can’t go through that another time. Please – make sure they never, never do that to us again.”

Tue, 02/01/2011 - 20:02 | 925721 prophet
prophet's picture

Might these be attempts to slow down (hard land) China?

Wed, 02/02/2011 - 02:18 | 926469 Orly
Orly's picture

Ye think?

Tue, 02/01/2011 - 20:18 | 925773 Robsabi
Robsabi's picture

Sudden Debt Dude: the above essay is by Johann Hari, from the July 2 edition of The Independent.

Give credit where credit is due, fer chrissakes!

http://www.independent.co.uk/opinion/commentators/johann-hari/johann-har...

 

Tue, 02/01/2011 - 18:33 | 925449 kengland
kengland's picture

Why is it this guy can say "rally on" in three paragraghs and you folks will discuss it, maybe even accept it, yet HW says pretty much the same thing and you revert to the 7th grade lunch table with funny faces and the like?

Tue, 02/01/2011 - 19:13 | 925585 Boilermaker
Boilermaker's picture

Because Harry is a dickhead.

Tue, 02/01/2011 - 18:34 | 925451 Tic tock
Tic tock's picture

what use is any of this wealth without the humanity and wisdom to use it.

Tue, 02/01/2011 - 18:42 | 925475 Sudden Debt
Sudden Debt's picture

wealth is cool to spend like crazy. You don't need to be a einstein to do it

Tue, 02/01/2011 - 18:37 | 925460 topcallingtroll
topcallingtroll's picture

I can never figure out those europeans. They want the euro to survive but the core doesnt want to subsidize the periphery. Probably.core and periphery will compromise and stick a third party with the bill.

Tue, 02/01/2011 - 20:11 | 925751 Racer
Racer's picture

And buy back sold a couple of days ago scam continues for first of the month CON job

Wed, 02/02/2011 - 00:30 | 926310 Yen Cross
Yen Cross's picture

Now that the markets have settled into cozy mode. Now I rock and roll. Futures in commodities, risk currencies and bond spreads. Get er DONE.

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