If over the past several days the market has seemed as if it is acting more irrational than normal, there is a simple explanation for this: the volumes across all products have collapsed. This includes equities, bonds, single name CDS and index CDS. In essence the market has virtually ground to a halt as the chart below demonstrates. Why? There are two explanations: one is that this gradual shut down of the market is in fact an unintended and delayed consequence of the MF Global bankruptcy, which has seen material liquidity withdrawn from the non-TBTF, which in turn is impacting overall market stability and functioning. The other theory, espoused by BofA's Hans Mikkelsen in tonight's Situation Room publication is that this is nothing short of a boycott by the market on the ECB, and thus the global capital market system, in an attempt to force the European central bank to resolve the helpless situation in which Europe finds itself, where on one side Germany is staunchly against printing more currency for fears of hyperinflation, and instead demands changes to the Eurozone treaty whereby everyone hands over sovereignty to an uber Eurozone headed naturally by Germany, and on the other we have France et al. pushing for immediate monetization but without transfer of sovereignty to Merkel. Obviously the risk is that should Merkel, who has all the levereage, be pushed too far she may simply balk and say "nein, nein, nein" in the process killing the EUR with one statement. Of course Germany will lose from this chain of events as well, which is why as we have claimed for nearly a year, the fundamental equation for Europe is whether the opportunity cost of constantly bailing out European countries and/or taking on the risk of hyperinflation is worth the benefit gained by German exporters from not having a strong Deutsche Mark. We don't know the answer. But apparently BofA does: "We are all waiting for the catalyst to a better or worse market - to us this means that the markets are now waiting for the ECB to step in." And naturally, just like with Deutsche Bank which put together the case for intervention, the outcome is one where the ECB will do everything in its power to resume the Risk On posture. So under what conditions will the ECB step in? Well, BofA conveniently gives us the answer to that as well. Let's dig in.
First, this, according to Bank of America, is how the market is institutes a boycott on the ECB:
Another day, another country sets new highs in interest rates. This time it was Spain following a 10-year auction that cleared at a record yield of 6.975% (vs. 5.433% previously). That represents just the latest episode in a succession of events that sustain the market concern that Europe is not up to its task – in which case the risk of a significant sell-off in the markets is high. Faced with such binary outcomes from an inherently political process, many investors naturally choose to sit on the sidelines and liquidity further dries up. Thus we have seen significant declines in trading volumes of high grade and high yield bonds, as well as single name CDS and index CDS products. We are all waiting for the catalyst to a better or worse market - to us this means that the markets are now waiting for the ECB to step in. The good news is that it seems the European situation gets resolved in a way that allows US markets to decouple and get back to business sooner rather than later – one way or the other. While the relevant time horizon is highly uncertain it feels more like a matter of two weeks than two months.
In other words, if the ECB persists in its prudent obstinacy, very soon one ES contract or $5MM notional in IG will move the completely frozen market by several percent. And this is precisely what the ECB will want to avoid. That and other things, which is precisely what the Risk On, "inverse" vigilantes will pursue in order to get the ECB to backstop all European risk with German taxpayer capital.
And while we have presented far more in depth analysis on the issue before, here is the broad strokes under which conditions the ECB will have no choice but to intervene:
The ECB may ultimately be prepared to engage in a much more aggressive expansion of its balance sheet, and thereby avert the end of the road for the euro area. However, in our view the ECB is only likely to do so if the crisis threatens to trigger the following:
1. A complete freeze of interbank markets;
2. An acceleration of deposit outflows or wider bank deleveraging affecting funding for peripheral banks and leading to widespread bank failures in the periphery;
3. An adverse feedback loop developing through rising refinancing costs from the sovereign to non-financial corporates via the domestic banking system, which leads to a deterioration in the growth outlook and therefore debt sustainability, reinforcing the rise in sovereign funding costs;
4. Consecutive failed auctions for a European sovereign not currently under a troika programme.
Since we already have seen each of the above 4 bullets in some level of activity, it is only a matter of figuring out which is the weakest link and will be punished the most by the big banks to get Dragi to cry zio.
In fact , BofA has already prepared the script that Monti should deliver to Germans to make it seem that he is not "really" monetizing
In our view, the ECB could proceed with QE without being accused of monetizing the debt as long as it does not target a specific sovereign by arguing:
1. Yield volatility disrupts the normal monetary policy transmission mechanism: the ECB would announce unlimited purchases of bonds to keep interest rates below a pre-determined level. The ECB would not necessarily need to announce its yield target;
2. Deflation is a threat (which was essentially the Fed’s argument to proceed with QE): the ECB would commit to purchase a basket of all sovereign bonds including Germany’s, together with a commitment to maintain interest rates at a very low level over the medium term (akin to the Bank of Canada in 2009-10). In addition, committing through low interest rates all along the yield curve should also engineer a depreciation of the euro, which would support adjustment.
And yet, there is a "but"
In our view the ECB can only alleviate current tensions, but a permanent solution has to acknowledge the implicit fiscal transfers that are increasing across the euro area, and centralise national budget caps at the European level.
In other words, as Peter Tchir explored earlier, the endgame of ECB intervention is nothing but a comprehensive European Fiscal union: precisely the outcome that Germany will be content with and that nobody else will want. In other words, in order to cross the chasm, Europe has to prepare for a lose-lose outcome: on one hand it will risk hyperinflation and alienating Germany by enacting monetization, and then it will threaten everyone else in Europe by forcing them to hand over all or part of their sovereignty to the one entity that has always had the most stable and vibrant economy in the Union.
And why? Simple - just so a few banks can get record bonuses for at least a few more years.