From Nic Lenoir of ICAP

Today 6 countries in Europe were the theater of riots. I highlighted in the past that voting turn-out has been on the rise in the past 8 years after a steady decline the 3 previous decades. During the credit boom fat and happy citizens had no time to vote, too busy producing or even more so consuming. Now with unemployment through the ceiling and poor economic perspectives people have started voting again. The next step is that they realize that no one in the political spectrum currently has any guts or brain and therefore no one offers a real credible fair solution, at least for now. When they do they burn things up. Because things are a little worse in Europe economically, and because the people there actually do realize the people in power are monkeys, they have now reached that stage of realization where burning things up is the logical response. Don't think the US will remain immune to this symptom of the new normal (unlike El Erian I have not revised up my forecast, and my concern is not slow growth but civil war). For proof there was a viral video going around yesterday with a man threatening a school board with a gun after his wife lost her job, and it sadly ended in a shooting. Sadly I have very much expected these incidents to become common place and it is certainly going to get a lot worse. I almost wonder if the most fair, clairvoyant, charismatic, and pro-active politician could help us prevent true chaos. I suppose the real question is will someone come along directing the blame abroad to deflect the anger of civil unrest towards an international war. Do not shoot the messenger, I am simply outlining what I consider the most likely scenario. I pointed out in 2008 that the two biggest market crashes of the 20th century were 1907 and 1929... it does not take a genius to do the math.



Looking into what chaos will look like for the financial markets, the elephant in the room is the Euro. The only way it survives in any form is if countries start defaulting. Until then the problem will not go to rest. I strongly believe that defaults are much like treating generalized infection by cutting the worst looking limb. The problem is at the core, in the way it is designed: you cannot manage drastically different economies of countries with dramatically different cultures and laws using the same currency and interest rate curve. Defaulting takes care of the current debt accumulation by poorer countries trying to keep up with the Euro (not benefiting from the tailwind of currency debasement to boost prices in nominal terms they accumulate debt). However the fact is they will find themselves in the same predicament in 30 or 40 years at the latest for the same reasons. But by the same token I do think defaults are necessary, whether it is via outright haircut on debt repayment or by breaking up the Euro with the debt being re-nominated in original currencies using the Euro conversion, in which case a subsequent and immediate currency bloodbath for the PIIGS would be the defacto default.





The problems in the Eurozone will not go away, all the temporary fixes European politicians are trying to throw at the problem are less and less effective, because the market sees that the Euro itself is broken, and so the placebo effect has a shorter and shorter life cycle. For that reason I pointed out last Friday and Monday that because sovereign CDSs in Europe were close to their widest levels still and US swap spreads had tightened back to their lowest levels since the Greek episode in the European saga, it was time to buy 2Y swap spreads. We have seen quite a bit of widening since I first brought it up already, but nothing compared to what I ultimately expect. Of course FRA/OIS spreads are blowing out in tandem. Interestingly it's no the case for the EUR curve. While counter intuitive in theory, this comes from the market structure of the debt markets. European banks have loan portfolios (unsecuritized) they need to fund in USD, and those can't be pledged against EUR deposits or to a central bank. The ECB has also quite a few schemes allowing almost any toxic junk to be pledged to them for cash. Zerohedge had a very interesting observation the other day that the leverage of the ECB is about 6 times that off the Fed. That's about the only thing that makes the Fed looks good. Also the shadow banking system is a lot more developed in the US than in Europe, so when things freeze it picks up momentum and dimension a lot faster in USD than EUR. For all those reasons, USD Libor settings were a lot more sensitive to market conditions during the Greek crisis than Euribor settings. Expect the same this time around. The attached chart of the 2nd IMM FRA/OIS in USD and EUR shows it more clearly than words could.





However it does not mean there are no traces of the damage in European Fixed Income. I have added to this email a spreadsheet where I calculate the "average" eurozone government yield curve using debt-by-maturity compounding. That gives us a quick way to see who are the countries borrowing cheaper than average, and who are those borrowing at a higher cost. Using that logic if we assumed the market premia for the overall debt-load of Europe remained constant if debt was socialized at the Eurozone level, it would cost 17Bn Euros a year to Germany and almost the same to France to keep the PIIGS in the union. If you don't think it sounds so bad, try to think what people in the US would say if Congress voted a $100Bn a year aid to Mexico. I am not sure what the current duration on a perpetual bond is, but it is equivalent to well over a trillion aid package. Not something people should take lightly.



Using these results I also looked at the spread between 2Y OIS (or EONIA fo Europe) and the 2Y government yield (or the 2Y average "Eurozone" sovereign yield). There you see the full damage much more clearly. While 2Y OIS and 2Y US Treasury yields are within 10bps of each other (mispriced? selling US treasuries against OIS is surely a great low carry fat tail insurance!), 2Y average sovereign yields trade over 120bps above EONIA. So if you are not seeing those Euribors getting crushed i tandem with the frnt Eurodollars on this move, you can see that dynamic is the same in terms of fundamental, but market structure and balance sheets mean the mole pops out of another hole. It is a legitimate question to ask whether Euribor settings should set higher. I am working on a combined average CDS for European banks contribution to Euribor weighted by market cap as I intend to show that the Euribor setting in its current form is useless and it should be modified as ultimately it is never good when your benchmarks are completely detached of the reality. But that last bit is for another day.





Good night and good luck trading,



Nic