Ad Hoc Commentary – the EUR euphoria

As expected, we have reached the EUR euphoria stage after our expected Jackson Hole disappointment. Despite our Dow Jones industrial making an eye-watering 1.87% jump overnight, yours truly is not bullish. Sorry bulls.

What we are likely seeing is the preparation for the temporary withdrawal of Greece from the Eurozone. The ECB unlimited bond buying program is necessary to avoid volatility/contagion to Italy and Spain. We remember that the Troika returns to Athens today:
The reception should be less warm than usual.

A temporary withdrawal from the Eurozone might be Greece’s only chance of getting out of the vicious spiral of austerity and growth. It is probable that we will see a temporary Grexit to regain competitiveness with concrete plans to be readmitted. Pundits are calling for a Jan 1 2013 Grexit. Assuming they are right, preparations must be done now.

To avoid a European meltdown, the EFSF/ESM would have to protect Euro-wide deposits (including Greeks). This ensures that depositors do not continue with pointless Great Depression era behavior of capital flight – from Spanish banks to German banks, and so on.

To give credence to the European solution, the IMF would need to help re-capitalize the European banking system. A global effort is warranted because failure to do so will imperil the global banking system to the detriment of the world economy. Of course, Euro-wide banking supervision is a prerequisite.

The EFSF/ESM would ultimately serve as the ‘European treasury’ and thus need more firepower. The EFSF/ESM and ECB would likely have to embark on a collateralized funding relationship. Calling the EFSF/ESM a bank is simpler, but not politically feasible. So, the EFSF/ESM relationship will be a repo relationship, not dissimilar to the relationship between the American TALF and TARP in 2008.

We had come a long way. We remember that it all started in Oct 2009 when the newly elected PASOK led by Papandreou announced that the 2009 deficit was going to be much bigger than previously claimed. Mr Market jumped on it when it became clear the new politicians had no intention to fix the deficit. Now nearly 3 years later, we are seeing a solution.

The solution in sight is on German terms. Don’t let the appearance of the Italian Super Marios taking charge fool you. Aunt Merkel likely played along because debtor Italy had the capacity to bring down creditor Germany. Aunt Merkel could not openly champion the lira-zation of the ECB because that would be political suicide in German politics. Since it is on German terms, don’t dream on the resumption of growth until there is a change in the German attitude towards Keynesian economics.

The risk ahead is the well known US and Japan fiscal cliff. We should also not underestimate Israel and the quickly worsening geopolitical calculations.

Good luck all.