If It Smells Like A Funding Crisis And It Looks Like A Funding Crisis...

Submitted by Nic Lenoir of ICAP

Well, it must be a funding crisis. For all those who have been talking about rate hikes, here is a little reality check: we are on the verge of a full blown funding crisis at the sovereign level and central banks have just only started withdrawing liquidity.

To be sure two factors are at play: the explosion of sovereign CDS's or in other words sovereign credit spreads, and the withdrawing of liquidity.

I have long been convinced sovereign CDS's would be the next stop for the wreck train, but for a while last fall it seemed like we might have a window of recovery, and would have to wait for the roll-over of the business cycle before the market adresses the issue. Greece, however small, provided the spark that ignited the powder keg when the new administration decided to clear its name and reveal the true nature of their government's books and deficit when it took over. It was all downside from there. Greece's ability to keep rolling its debt down the road is pretty much null, despite a lot of the austerity measures committed to. Then of course as we all have learned from recent experience with the banking crisis contagion is quick to arrive, and since most countries are in a precarious fiscal situation the market is not short of ammunition to spread the fire. Let's be clear: if Spain officially only has a debt to GDP ratio roughly equal to 65%, its consumers are massively leveraged, and as a result so are local banks. I hear a lot of people out of Europe saying: "the US is no better, this is ridiculous we are just as solvent as they are". Maybe, but a market is governed by supply and demand and right now no one wants European bonds. As numerous instituations some bigger than other have found out: when you have leverage you are only as solvent as you can roll your debt.

The other factor at play here is the actual funding difficulties we are seeing resurface in the money markets. Remember the ECB has pledged not to renew its 1Y LTOR maturing in June. We expected them to be very pre-emptive and nurse the markets' expectations announcing a ramp up in lower maturities to smooth the liquidity gap. Arrogance being a French natural attribute, Trichet did not really bother with such formalities. At the same time the Fed has slowly been pulling the liquidity rug letting various liquidity programs mature (the federal reserve's balance sheet shrinkage has been covered by none better than our chief economist Lou Crandall for Wrightson ICAP). Risk assets were slow to react in particular US equities (supported by USD strength they were the last to turn this time) but are now catching up. We discussed at length over the past year how the market ramped up every day the Fed injected liquidity in the markets via QE and how the entire advance since the 666 lows was less than the move between noon and the close on QE days over that period! Well now we not only lost our turbo-charged market boost: liquidity should be a drag on equities. FX forwards have showed that USD funding cost has been creeping up and now comes at a premium: the days when European banks are scrambling for liquidity could be back faster than one thinks if one believes the EUR/USD cross-currency basis.

Let's take a step back and look at what the possible solutions are. The first is what Angela Merkel was quoted mentionning as "assisted default within the Eurozone". While I completely agree that defaults are probably inevitable whether it is now or 3 years down the road, it was a calculated political snake move on her part to bring it up publicly like that right on the heels of the Greek bailout and following the European market holiday yesterday. That opens up a door Mr. Almunia didn't know existed ("there is no default in the Eurozone", almost as classic as Trichet hiking in 2008), and also pushes the market down that path. Once you have officials going down that route publicly everybody owning Spanish, Portugese, or any other vulnerable sovereign bonds is feeling a little less upbeat about the Greece-IMF bailout. If that is the road we are following then surely it will be drastically deflationary, the Euro will keep punging and the USD appreciating, taking down EM equities and commodities. Not even Gold is posting a nasty reversal on the day and if the situation is not contained then we are moving to an environment where owning gold is not the answer.

The second is a further string of bailouts. We are not going to get any more help from the Germans, at least certainly not until Saturday because of the upcoming election (was Merkel's statement today part of her own local political strategy?). So that means the IMF a.k.a. uncle Sam is going to have to step up to the plate and shell out some cash. It's a slippery slope, because after Spain comes England, and then Japan, and then the US! The last 3 countries have the possibility to simply devalue their currencies aggressively which Europe can't do as easily. Politicians and central bankers are certainly aware of this and even though sometimes defaulting or cutting massively social programs is what is needed, they will choose the populist way and try to print their way out.

Either way there is so much you can run but you cannot hide when the deflationary ghosts come to haunt an economy with an aging population and massive global overcapacity. Some believe we can get an air-conditioned house and an SUV to every family in Asia and Africa if they experience the same credit boom we have over the past 30 years and delay the time bomb, but I don't think it is a possibility as they do not have the economic and banking infrastructure to achieve it. China is trying to have a fast forward bubble and blow up in 15 years twice as big as we have in 50. I am frankly scared of what will happen when that ponzi scheme comes to an end. For more on our economic views and the deflation prospects I attached the powerpoint of a presentation I gave recently to an investor panel.

I expect the Fed to step in if markets don't settle and re-open the currency swaps channel with other central banks as the USD liquidity squeeze intensifies. Central banks like that of Venezuela or Angola which issued bonds in USD much to our outrage last year should be left out to hang dry as it is the only way they will learn their lessons. Until the money markets are not showing signs of compressing fundind premiums all around and the USD squeeze is not halted, expect equities and commodities to suffer greatly with the major liquid sovereign bond markets as only safe heaven. If it gets to where even these aren't safe, we are afraid that your cash will be safest placed under your mattress. After all we did not deleverage our economy after the 2008 crisis, banks are still holding most of the assets that put them in trouble in the first place, so basically we have done nothing but taking distress to the sovereign stage. It is time to face the structural problems of our economy as we will not be able to go on another run like that from 1982 to 2007 boosted by +280% in the debt to GDP ratio.

We remain convinced USD bulls (short EURUSD core remains the best trade for 2010) against almost every cross out there (exception can be made for JPY though it has not shown traditional risk aversion or correlation to US Bonds of late so watch for the decoupling as a sign of a deterioration of the Japanese sovereign bond market). Until the liquidity situation is resolved we would also be cautious with gold as it has posted a nasty reversal today on the last resistance 1,185/1,187 (c=a since the lows) we had highlighted before the run towards new highs. Once default fears are batted away with the liquidity bat then not doubt the Gold bullish trend will return.   

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