All The Roads Lead To Default, But Which Will We Take?

From Nic Lenoir of ICAP

As a disclaimer to this update, I just want to reiterate once again that I firmly believe that the Euro is not viable, at least certainly not the way it is designed and I think the flaws in its conception are so profound that dissolution makes the most sense.

With this assumption in mind, let us look at what the solutions are to the current woes. The individual bail-out route is not an option. When dominoes fall in panic the speed at which they fall tends to accelerate exponentially. Rewind the tapes to late July 2007: American Home mortgages files. The market goes on to make new highs but in January Bank of America takes over otherwise soon defunct Countrywide and by March Bear Stearns is belly up. The forced hand out to JP Morgan appeases the market temporarily, but by early September Fannie and Freddie are de facto nationalized, and so is AIG, Lehman collapses, Wamu is taken over by JP and at that point the government has no choice but backstop the entire system. Well, this is not unlike what we are witnessing here: We first had Iceland in November 2008, then Greece in the spring of 2010, now Ireland. Make no mistake if you let that fester enough or decide to bail them one by one without attempting a larger scale resolution by January Spain Portugal and possibly Italy will have been downgraded several notches, LCH will have raised the margins on all those bonds, and French and German banks will start dragging their country down the same slope.

This is precisely why Germany is at it trying to push for restructuring, as they fully recognize that if the burden is carried by governments exclusively contagion will be much sharper so they are hell bent on having the private sector share some of the pain and thereby not dilute their balance sheet as much. They also probably recognize that if the ECB, the IMF, and the richer countries in Europe shoulder the load, they give free reign to private investors to load up on stocks and precious metals, and reinvest some of the profits to pay for the cost of long CDS positions against sovereign entities, and unlike the Fed they do mind. It is also probably a good way to make sure governments play ball enforcing austerity. Now whether the market would handle well a default is a separate question. I personally think it would not, and if Irish debt holders take a haircut it could well make Portugese and Spanish bondholders quite uncomfortable, but again as pointed out earlier I don't think there is an easy solution. If debasing the Euro is not an option, the best might well be for the countries in bad shape to simply exit the Euro. That too would have a domino effect but sometimes you have to cut your losses.

So here are the potential solutions:

I/ Bail-out countries individually as has been the case so far: the market rejected Ireland's bail-out so it is extremely unlikely as failure is quite obvious and Germany is opposed to it

II/ Outright monetization by the ECB: so far intervention has been sterilized which has not proven too helpful. Germany is again highly opposed to this type of resolution.

III/ Create a mechanism that involves the private sector and the EFSF: Germany has been pushing for this solution from day one but obviously no solution has been found, and if you start restructuring Irish debt you run the risk of a flight out of other PIIGS's bonds

IV/ Let the PIIGS out of the Euro, or the PIIGS show themselves out / the Euro is disbanded

I cannot stress enough that an entire generation of politicians in Europe view the Euro as their legacy (they already had tried a scheme to control exchange rates which failed in the early 90s). They are extremely unlikely to let go easily as they think Politics should prevail over finance (and reason, gravity, common sense, law, decency etc...). But because deficits are structural, European economies are too different to be managed under the same exchange rate and borrowing rate (Spanish and Irish housing bubbles anyone?) and eventually this will prove too much to overcome and outcome IV will prevail.

In terms of price action US treasuries were dragged lower this morning mainly because Libor rates spiked. We have had heavy volume trading in the front Eurodollar contracts as the market braces for worsening credit. This shall prove an opportunity to buy the front end in US treasuries as seasonals are usually good in December, the uncertainty in the market should provide a decent safe heaven bid, and a lot of longs have been flushed out the past few weeks. I also continue to favor being long schatz. Equities have been well supported as the Fed injects billions of liquidity in the system daily. A break above 1,204/1,212 would be resolutely bearish, but conversely if we start dropping below 1,170/1,172 the market has a solid 40 ticks of further downside in S&P futures. I feel that if liquidity is the main driver and the reason to get long equities, then precious metals make more sense until we see a lot of improvement in data. Watch for a break above 1,390 which is now resistance in Gold.

Good luck trading,



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