The tail wagging the dog…
This week has seen the Euro fall to fresh lows against the US dollar, as speculators have attacked the viability of the whole European single currency endeavour. On Monday $1trillion was committed as a backstop to the currency by the big Eurozone countries. While there is no intention of using all of that sum, the “nuclear” size of the backstop was supposed to act as a deterrent to would-be speculators who have been betting against the Euro. The governments were trying to say to the financial markets: No matter how much you bet against us, we are united and we have more capacity to back our currency than you have to short it. On Monday the markets believed this, and the Euro along with stocks across the world went up in value.
On Tuesday the markets began to call the bluff of the Eurozone, questioning a) whether the Eurozone leaders are truly committed to their currency, and b) whether they are truly capable of backstopping the currency if they want to. At the end of the week the consensus view seemed to be negative on both a) and b). Rumours of Nicolas Sarkozy threatening to pull the French out of the Euro certainly didn’t help, regardless of their truth. A conspiracy theorist might speculate that such headlines were the work of some sneaky hedge fund with a large short position on the Euro.
Beyond the rumours, the facts don’t look good either; the known knowns as Donald Rumsfeld would call them, are that across the Eurozone there are current public spending commitments that amount to $1.5trillion, and $3trillion worth of government debt needs to be refinanced. Government debt in Europe is far greater than in the US. Property values are significantly more overvalued than in the US. The corporate sector is considerably more leveraged than in the US. The banking system is much more leveraged than in the US and capitalization levels of banks are probably inadequate.
Furthermore, the multi-party parliamentary systems of most European nations are dysfunctional. The inability of European institutions to effectively deal with the crisis may trigger political and social unrest not seen in many decades. It remains to be seen what a coalition government in the UK can do to co-ordinate its efforts to deal with the UKs £170bn annual deficit; trying to push through serious changes and relying on a coalition partner who is ideologically very different won’t be easy.
In Germany Angela Merkel’s weak coalition government is facing severe problems in attempting to address public spending. Her conservative-liberal coalition was hammered in key regional elections on Sunday amidst increasing anger over the bailout deal that will cost her country £19 billion.The result stripped her government of its majority in the country’s Bundesrat (the upper house of parliament) and her ability to pass reforms cutting public spending. Germany’s Der Spiegel magazine said that up to 10 regional Christian Democrat leaders had begun plotting to remove her after her Greece policy “failed its first democratic test”.
While it is undoubtedly clear that the Eurozone has problems of both a fiscal and political nature, I have a big concern about the nature of the way in which financial markets can force a situation to suit the bets of the market’s participants. As of this weekend the Greek prime minister has stated his intention to look into the idea of suing US banks or hedge funds for making a bad situation worse. Sour grapes many may say, as most of Greece’s problems are entirely of their own creation.
Where he may have a valid point is in relation to the credit derivatives market. These side bets on market outcomes are now sufficiently large that they are actually impacting the outcomes in the underlying markets. At current levels, the notional amount of credit derivatives outstanding is around nine times the underlying notional debt that they represent. Without going into too much detail, this is a massive issue.
A credit derivative has 2 participants betting on each side of a ‘real outcome’, just like 2 people matching their views on Betfair. In the Betfair case though the outcome of the 4.30 at Ascot is unaffected by the bets that are taking place ‘on the side’. In the credit derivative markets the bond prices of Greek, Spanish and Portuguese debt (for example) are being priced using their credit derivative prices as the benchmark. As a consequence those taking the side bets (if they can do it in sufficient size) have the ability to influence the price that these countries will pay on their debts, potentially to the point where they can affect the speed at which a country (or company) heads towards bankruptcy.
The current price Greece needs to pay on it debts is unsustainable, making bankruptcy a potential self-fulfilling prophecy for those betting against the country.
When George Soros “broke the Bank of England” by forcing the UK to exit the ERM (Exchange Rate Mechanism) in 1992 he had sold short around $10 billion worth of pounds sterling. In doing so he profited from the Bank of England’s reluctance to either raise its interest rates to levels comparable to those of other ERM countries or to float its currency. The size of his bets against the currency were sufficient, over time, to make the Bank of England withdraw from the ERM and devalue. As a consequence Soros earned an estimated $1.1 billion in the process, and has ever since been dubbed “the man who broke the Bank of England”.
By comparison Soros was a small market participant when measured against some of the groups betting against the Euro today.