Cracks Beneath The Façade

Cracks Beneath the Façade
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The Week Ahead


On Thursday, Qu Xing, director of the China Institute of International Studies, a Foreign Ministry think tank, told reporters that China doesn’t want to see debt restructuring in the Eurozone and is working with the IMF and countries involved with the debt crisis to avoid it. Speaking at a press conference during a visit to Hungary, Premier Wen Jiabao said, “China is a long-term investor in Europe’s sovereign debt market. In recent years we have increased by a quite big margin holdings of Euro bonds. In the future, as we have done in the past, we will support Europe and the Euro.” (China to remain long-term investor in Europe’s debt). Sunday, on a tour of the Chinese-owned Longbridge MG Motor factory in Birmingham, Premier Wen told BBC it will lend to European countries, and also has plans to stimulate domestic demand and reduce its foreign trade surplus. (Reuters)

China’s stated position prompted Zero Hedge to ask, “Will the third time be the charm for the Chinese ‘white knight’ approach to Europe, where it has so far sunk about $50 billion in bad money after good?” Saturday, Zero Hedge reported that China’s European Bailout (And TBTF) Bid Hits Overdrive, As Wen Jiabao is Now in the Market for Hungarian Bonds. “It seems China has learned from the best, and either knows something others don’t (except for the SHIBOR market of course) or is actively preparing to become Too Biggest To Fail by making sure that if something bad happens to it, literally the entire world will follow it into the depths of hell.  Sunday, ZH wrote, “As expected, China is the new IMF… All this means is that China will do everything in its power to prevent the ECB from launching an outright unsterilized monetization episode, which will double the amount of importable inflation (plunging EUR) to hit the Chinese domestic economy, and destabilize the already shaky stability, so critical for the Chinese communist party.” (China Says It Will Bail Out Insolvent European Countries.)  

It’s good to know that China has its problem with inflation now under control. 


Greece has a population of just over 11 million people. Compare that to the New York City metropolitan area population estimated at 18.9 million. It may seem strange that Greece’s travails might greatly affect the global economy, but the potential repercussions from a Greek default become more significant when considering leverage and derivatives. Data from the International Monetary Fund (IMF) show that German banks are heavily leveraged, holding 32 Euros of loans for every Euro of capital they have on hand. Other banks are leveraged to the hilt as well. Belgian banks are leveraged 30-1, and French banks are leveraged 26-1. Lehman’s leverage at the time of its collapse was 31-1. U.S. Banks are paragons of sanity by comparison, with an average leverage of only 13-1. (Europe’s sickly banks) France and Germany are the countries most exposed to Greek debt through bank and private lending and government debt exposure (charts below). 



Derivatives present another potential minefield. As Louise Story wrote in the NY Times, “It’s the $616 billion question: Does the euro crisis have a hidden A.I.G.? No one seems to be sure, in large part because the world of derivatives is so murky. But the possibility that some company out there may have insured billions of dollars of European debt has added a new tension to the sovereign default debate… The looming uncertainties are whether these contracts — which insure against possibilities like a Greek default — are concentrated in the hands of a few companies, and if these companies will be able to pay out billions of dollars to cover losses during a default.” (Derivatives Cloud the Possible Fallout From a Greek Default)

Michael Hudson explored the differences between what happened to Iceland and its debt crisis, and what is currently happening in Greece.

“The fight for Europe’s future is being waged in Athens and other Greek cities to resist financial demands that are the 21st century’s version of an outright military attack. The threat of bank overlordship is not the kind of economy-killing policy that affords opportunities for heroism in armed battle, to be sure. Destructive financial policies are more like an exercise in the banality of evil – in this case, the pro-creditor assumptions of the European Central Bank (ECB), EU and IMF (egged on by the U.S. Treasury)…

“The bankers are trying to get a windfall by using the debt hammer to achieve what warfare did in times past. They are demanding privatization of public assets (on credit, with tax deductibility for interest so as to leave more cash flow to pay the bankers). This transfer of land, public utilities and interest as financial booty and tribute to creditor economies is what makes financial austerity like war in its effect…

“One would think that after 50 years of austerity programs and privatization selloffs to pay bad debts, the world had learned enough about causes and consequences. The banking profession chooses deliberately to be ignorant. ‘Good accepted practice’ is bolstered by Nobel Economics Prizes to provide a cloak of plausible deniability when markets “unexpectedly” are hollowed out and new investment slows as a result of financially bleeding economies, medieval-style, while wealth is siphoned up to the top of the economic pyramid.

“My friend David Kelley likes to cite Molly Ivins’ quip: ‘It’s hard to convince people that you are killing them for their own good.’ The EU’s attempt to do this didn’t succeed in Iceland. And like the Icelanders, the Greek protesters have had their fill of neoliberal learned ignorance that austerity, unemployment and shrinking markets are the path to prosperity, not deeper poverty. So we must ask what motivates central banks to promote tunnel-visioned managers who follow the orders and logic of a system that imposes needless suffering and waste – all to pursue the banal obsession that banks must not lose money?

“One must conclude that the EU’s new central planners (isn’t that what Hayek said was the Road to Serfdom?) are acting as class warriors by demanding that all losses are to be suffered by economies imposing debt deflation and permitting creditors to grab assets – as if this won’t make the problem worse. This ECB hard line is backed by U.S. Treasury Secretary Geithner, evidently so that U.S. institutions not lose their bets on derivative plays they have written up…

(Michael Hudson’s Whither Greece – Without a national referendum Iceland-style, EU dictates cannot be binding for more.)

Stocks & Treasuries

Lee Adler of Wall Street Examiner appears somewhat more bearish than he had been recently. In rigour Mortis Market, he warned, 

“The market was in prime time for a 13 week cycle upturn last week, and it failed miserably. The up phase is now in imminent danger of an early abort that could lead to a severe short term decline. At best it looks like they would only be able to hold the trading range for a couple more weeks. A weak bounce or two could be the rigour mortis rallies…”

Lee also discussed the Treasury market in Treasuries – Look at ‘Em, Dey Panickin!: “The Treasury calendar was light this week with a paydown on Thursday sending $9 billion in cash back to the holders of the maturing paper. The Treasury market panic continued, but there were cracks beneath the façade. The indirect bid fell apart on the 4 week bill and was very weak on the 30 year TIPS. Considering the paydown, the weak indirect bid suggests that smart money is still fleeing the Treasury market, and it looks like the smart money, or maybe scared money or just short of money, is the foreign central banks (FCBs). That continues a year long trend, and it’s very bearish for stocks and ultimately will be for Treasuries as well.

“The Treasury market buying continues to be driven by fear and loathing of everything else, which is entirely rational, but ignores the fact that Treasuries are no safer than the paper that investors are fleeing. The only thing keeping the Treasury game going, as with any Ponzi scheme, is that people are still buying the stuff. It sure has nothing to do with the fundamentals of US government finance, which is a joke. The US government uses the incoming funds from its debt sales to pay off earlier investors, and it skims the cream to pay its bills. We all know where this is headed, but first there’s a real likelihood that yields could head lower for a few more weeks.

“I’m not sure what will drive it after QE ends on Thursday, but panic usually begets more panic. Part of the problem is that the Primary Dealers are right in the thick of those panicking. ‘Look at dem! Dey panickin! My God Mortimer! He’s right! They are panicking!’ Apologies to Eddie Murphy and Ralph Bellamy…

“Next week’s calendar will be a real challenge, with a heavy slate of notes settling on Thursday and only $18-20 billion in POMO left to go to support it. This will be a critical test. If the market doesn’t hold up well, and in particular if the FCBs again show a pattern of weak buying indicated by the indirect bid, it will only get worse with the Fed out of the game. The technical indicators say that the Treasury rally will continue. That’s very bad news for stock market because it’s likely to be the source of much of the cash driving yields down (Wall Street Examiner)

European Debt & Credit Default Swaps

In an interesting article, Brian Edmonds wonders whether the U.S. is too big to fail, linking the debt crisis in Greek to U.S. Money market funds holding large quantities of European debt. “While many investors are focused on the precarious situation surrounding Greek debt, and whether the rest of the so-called PIIGS (Portugal, Italy, Ireland, and Spain) might follow closely behind, there is a less-publicized yet equally dangerous element in the mix:

“If Greece defaults, who will be holding the bag?… Recent publications have pointed, as one example, to the exposure of big U.S. money market funds that hold large amounts of short-term European bank debt.

“The biggest way that the risk of default is mitigated is through credit default swaps, in a largely unregulated, over-the-counter (as opposed to exchange traded) marketplace where investors buy and sell protection against default on outstanding debt of corporations and countries. Sovereign debt swaps are the gorillas in the PIIGS room, but no one really knows if they are just 800-pound gorillas (large but manageable) or King Kongs (think AIG).

“Only if, or when, Greece defaults will we know who ultimately has sold insurance against that default.” (The U.S. is too big to fail, right?)

Week Ahead

The U.S. Dollar bounced off of a high of 76.3 on Friday and settled at 76.1, reminding us that our levels are more like trampolines than like walls. We currently believe the Dollar is apt to go down next week, which should be bullish for the markets. However, we are cashy and cautious again. Based on the premise that oil may be strong into the July 4 weekend, and the dollar may be weak, Phil suggested a trade idea for going long USO:

The next week $35/36 bull call spread is $0.61 and you can sell July $34 puts for $0.48 so that is a net $0.13 on the $1 spread. If USO makes it to $36 and holds it to next Friday, this can turn $650 cash into $5,000 (USO is now $35.83 with oil at $91.11).

We’ll be closely watching the Dollar and our Big Chart levels that have been working as support and resistance.

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