Apocalypse Europe: The Smell Of Draghi's Eau De Napalm

Tyler Durden's picture

As we look forward to tomorrow's scorched-earth policy-fest from Draghi-et-al., Jefferies' David Zervos, in his typically understated manner, notes "I love the smell of napalm in the morning. We are back in the kill zone - Apocalypse Europe." There will be no more strategizing, no more war games, no more speeches imploring the politicians to act. This is the real deal - a full scale European led global financial crisis that requires immediate and aggressive response from the only entities with the authority to act in the world financial "theatre".

Jefferies' David Zervos, I love the smell of napalm in the morning  

On the battlefields it’s not the heads of state, but the generals, colonels and majors that execute. These leaders have mandates - with the most important one being the dual mandate of the US Fed - "maximum employment and price stability". And now, the European fallout has become a clear and present danger to both the US recovery and the Fed's "potential" achievement of its dual mandate goals. The weak data last Friday (as well as many of the past couple months' soft economic releases around the globe) can easily be attributed to structural uncertainty emanating from Europe. And to be sure, the Fed has been warning us about this eventuality in nearly every FOMC statement for a year now - "strains in global financial markets pose significant downside risks to the economic outlook". Those risks are front and center, and there is only one key variable we need to look at to understand the level of the threat - the DXY. At 84, we are fast approaching the red zone!

Rather than discuss the evolution of the crisis response - and what that means for risk assets, the dollar and rates - I want to reprint an excerpt from our 12-Dec-2011 commentary entitled "Nurse Ratched bears down as the TBTF backlash boils". It was here that we put forth our roadmap for 2012 European crisis evolution and its impact on global markets. The views here still stand strong some 6 months later! Please read below -

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From 21-Dec-2011:

 

The European Nurse/Patient relationship is coming to a boil. The medicine is not acceptable to the UK as austerity also comes along with an added pill of over bearing financial market regulation. But most importantly, the medicine isn't working for ALL the patients. Political boils are brewing all over the asylum! For those that forgot about Greece, take a look at the latest news on PASOK over the weekend - the referendum man is back - http://www.athensnews.gr/portal/8/51314. Uh oh!!

 

With that in mind, every investor must make contingency plans for that day in 2012 when a red line flashes across the bloomberg news screen - "Greece misses coupon payment, CDS triggers, Drachma to return".

 

It’s going to be a very messy day. The equity markets will drop 5 to 10 percent, libor will spike and some banks will fail or be nationalized. More sovereign exits may follow and the trading days will be tense. It will be important to be liquid and agile. And it will be crucial not to get caught up with big exposures to SIFI banks, as it increasingly looks like the US and European officials want to tear these institutions apart. See the latest Gretchen Morgenson article below -

 

http://mobile.nytimes.com/article;jsessionid=CD8522211506B47FACD69A553BA...

 

The catalyst for TBTF/SIFI bank "unwinds" will likely be a Euro credit event. If there is one rule for 2012 it is - "move positions to exchanges". The world of bilateral OTC derivative trading is about to be purged. The good news however is that this credit event, and the ensuing SIFI bank run, will create a massive global coordinated liquidity response led by none other than the Colonel - QE3, CPFF, AMLF, TAF, TSLF, PDCF and TALF are all waiting in the wings. But this time the big banks will not get 800b in cash and a TLGP wrap - there will be losers. And for the rest us, a more stable world with all derivatives on exchanges will emerge.

 

The global central bank response to a fracturing of Europe and a breakdown of the SIFI bank oligarchy will be swift and aggressive, making short risk positions very difficult to cover. Further, policy will likely even preempt the Euro credit/ Sifi bank run event making short risk difficult to hold at all (much like it was in 2011). We will come out the other side with a massive risk rally and significant inflationary pressures brewing. One cannot afford to miss the exercise of the mother of all Bernanke puts! The key to 2012 is figuring out how to design a hedge for risk asset longs that brings you through the rubicon unscathed. Spoos + Blues maybe, Spoos + Agency MBS maybe, or maybe spoos + DXY does the trick. More on that later. Good luck trading.

 

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I would change nothing in this analysis! All three of those trades have made it through to this point with strong return profiles. And those who tried to short risk early were smoked. Importantly, we must stay prepared for the eventuality of aggressive action by our central banks - most importantly the Fed. It’s not an easy trading environment, but with the right hedges to a long risk asset position, there are great trades to do! This has been our core trading theme for many quarters/years now and nothing in the recent developments changes that.

We should all keep in mind that the Europeans have not been able to generate an effective response to their debt/deflation crisis as of yet, and of course it is having global consequences. This is why we are here again looking into the deflationary abyss. The ECB was only set up with a price stability mandate, and its leaders are hence much more constrained than Federal Reserve officials. Simply put, the European armies were not set up with effective weapons. In the US we have bazookas, tomahawks and howitzers. In Europe, they can barely agree to fire a musket. This unfortunate set up for Europe means that they can become a serious negative externality on the world without any internal ability to fix the problem. Of course, then it becomes incumbent on the rest of the world to directly involve themselves in combating Europe’s turmoil (sadly we have seen this movie a few too many times in the last 100 years).

As we look ahead to policy responses, it is the Fed that will continue to be forced to do the heavy lifting. If the ECB had strong leaders, that were willing to take some legal risk with the mandate, we would be in a much safer place. But based on Mario's pathetic (whiny) speech to the EU parliament a few days back, it is difficult to have high hopes on this front.

The Bernanke Fed however has not let us down since the crisis turned in early 2009. So why should we expect him to sit idly by and watch Europe destroy all his hard work? He won't! And while the Greek people look set to pull the rip cord in the middle of this month, we can rest assured that as EMU fractures, losses are realized and the Euro leadership vacuum fails to contain the fallout, the Bernanke Fed will not abandon the US recovery effort. Good luck trading.