Is The Sovereign Credit Crisis A Function Of Imminent Liquidity Tightening?

Many have wondered just what it was about the past month that has woken up the bond vigilantes from their euro zone slumber, prompting them to suddenly and aggressively punish deficit transgressors. After all, it is not like the massive deficits appeared overnight. Surely had the sovereign bond and CDS widening been more gradual the European authorities would have had no recourse to blame cash and CDS "speculators", whose actions have merely forced the market fundamentals to catch up with reality. Yet due to the sudden move, chaos is rampant, and any minute now 6 scapegoats are expected to be named, in an attempt to deflect anger away from fiscal blunders by various administration officials, whose incompetence is the primary cause for the PIIGS crisis. Morgan Stanley's explanation for the sudden and dramatic move has to do not so much with endogenous fiscal constraints, but more with the ever more prevalent opinion that the giant liquidity pump is coming to an end. Is the market merely pricing in the removal of liquidity and striking at those who will be impacted first when the tide finally starts to recede?

For a long time, we have stated that rate levels are unnaturally low and are a product of QE and other government support facilities. These liquidity and support facilities were ultimately responsible for the record-breaking inflows into bond funds from money market funds and has kept rates unnaturally low. But ultimately the sovereign credit markets will act to right this ship. As we are seeing in Europe, the plans for liquidity withdrawal are causing a differentiation in credit spreads as measured by sovereign CDS spreads (Exhibit 4). This is resulting in a rise in yields in many of the European peripherals. In a strange but predictable way, the market is seeking a center of gravity for relative valuations; simply put, this is an exercise in market efficiency.

Not surprisingly, the proposed resolution for Europe's fiscal problems would hinge, as always, on how Central Bankers are responding to the prevailing supply/demand climate in the region. Is Europe entering an inflationary or deflationary period? Morgan Stanley, following traditional economic precepts, is a believer in the former. As we pointed out yesterday, for a unique perspective on deflation as being the catalyst for deleveraging, we refer readers to Andrew Smithers' interview with Kate Welling.

At the crux of the current market risk story is whether or not the troubles in Europe are inflationary or deflationary. If the problems in Europe spread more broadly, it creates a significant headwind to growth that will lead to deflation. Already we are seeing signs that European growth may disappoint initially more optimistic forecasts and for fiscal austerity measures that are needed to reduce debt/GDP ratios (Exhibits 5 & 6). This is the deflation side of the story. On the other hand, the fix to the European situation may result in increased bond issuance, devaluation of the currency, delays in the central bank rate hiking cycle and rising risks for debt monetization. This is the inflation side of the story.

Ultimately, we think inflation wins. In a typical sovereign crisis, there are three common avenues out: growth, inflation or default. We put low probability on default and rapid growth. That leaves inflation. As we see it, the resolution for Greece and the peripherals will come in the form of a fiscal austerity measure combined with some form of capital raise through bond issuance to fund and support the resolution. This brings on the risk of more supply, debt monetization and money supply growth, which is inflationary. Fiscal austerity without a capital raise to support it is unlikely in our view because it may lead to deflation as it did in Japan and create a longer, deeper and more prolonged recession.

If QE, and more specifically the perception of how the Fedis approaching QE, is indeed the catalyst for sovereign credit spreads blowing out, the Fed will undoubtedly be aware of the negative spiral that would result once the peripheral risk shift to Europe's core, and subsequently to America, once, as Hoenig and Plosser demand, MBS purchases are not only halted but in fact sold off (the question to whom is oddly missing - there has not been any material flow into the MBS market from private players over the past year, and in fact we have seen the opposite). Will the end of QE, if it indeed occurs as expected in about 40 days, be the real catalyst for the next leg down? We have long held that particular view, which leads us to believe that the Fed will do all in its power to delay as long as possible the ultimate unwind of all economic crutches. While Goldman is very likely correct about no Fed rate hikes until the end of 2011, we would also add that QE, in some version, will persist well into next year unless Bernanke is willing to go through the September 2008 days all over again. At least practice makes perfect.