The road map to fiscal union

Post the collapse of the Soviet Union, have you ever thought about how the concept of planned economies was ever written and is possibly now resurfacing as a European Union version some 20 years later?

Effectively, we in the Western World now all work and operate in a market partly or fully financed/controlled by governments. Take France, for example, which might well be under attack whilst the good old dirigisme is as strong as ever. But for how long can this last?

Well from the viewpoint of disallocation of capital then probably quite some time due to the 'low cost' of mistakes, or rather low funding costs, but these exact funding costs are now at risk.

US investors exiting Europe
Over the last two weeks U.S. investors have pulled money out of European money market instruments, partly it seems due to pressure from U.S. authorities to do so and partly due to the contagion of the debt crisis to countries deemed untouchable two months ago: Italy and France.

The banks of the world still mainly tap into U.S. dollar funding - due to the size and liquidity of the U.S. market - so watching the Basis Swaps from USD to EUR is of key importance. The price is currently elevated at -77.88 vs a 12 month average of -35.40 but far from the panic of 2008.

Solution amid funding freeze
The next 'step' market wise in this Crisis 2.0 is more likely than not going to come from this side of the Atlantic. The European banks have plenty of funds short-term but beyond year-end and into 2012 the situation will deteriorate.

Basically we are talking about the risk of a funding freeze. For now however the temperature has just dropped below zero and the ice still needs to crystalise before we deem it safe to skate on.

Mer-Kozy's Red ears
On the political front the Merkel/Sarkozy meeting this week left "Mer-Kozy" with red ears. Proposing a levy on financial transactions was a desperate move playing to the domestic audiences but will never ever be practically applied, unless of course the purpose of it is to make sure Europe shuts down! The meeting showcased the inability of politicians to understand the message of markets, which to me reads as follows:

• You (politicians) socialised the risk in 2008 now we need to democratise the loss. (Note the change from using risk to loss!) The market wants to deal in solvency not in liquidity.

Ireland in shape?
How is it Ireland after taking a 55 percent hair-cut on its banks and owning up to its austerity is now moving forward again with a current account surplus, a debt to gdp stabilised at 110 per cent and soon even real growth?
Meanwhile the endless transfer of 'free money' to the 'bad guys' or the countries only committing tofuture austerity is still marred by negative growth, productivity and fiscal balances.

ECB QE and more Bernanke tools
When will the world learn? Well, a friend of mine put it like this: 'only when everyone is unhappy will there be real change'. Where then is the point?

Well, first the Master Planners will force the now non-independent European Central Bank to convert to Quantitative Easing. There is already talk in the marketplace that recent support of Spanish and Italian markets has not been fully sterilised, so has the game begun?  Probably!

Next week Jackson Hole will confirm the initiation of Operation Twist - the buying of medium-long term bonds against selling shorter-term bills as the final tool in the box of non-surprises Bernanke et. al. has for the market. (I have written about this extensively over the last few months.)

The mighty Swiss Franc - once in a life-time opportunity
Finally, the mighty Swiss Franc. I'm writing this "Steen's Chronicle" from Zurich Airport on my way back to Denmark. This weekend will most likely see the 'floor' being introduced. The people in the know here are now selling CHF and buying Gold - which makes perfect sense.

My take is simple: over time the micro economy will take care of this over valuation of the Swiss Franc. Every single Swiss CEO should right now be on a plane to go buy their competitors and strategic wish lists. The buys just got 40 per cent cheaper. Every swiss person should be on holiday spending, buying like crazy. This is once in a life time BARGAIN SALE.

Furthermore the Swiss economy will move into deflation - structural unemployment will rise and keep a lid on labour costs. 1.00 EURCHF is too expensive - 1.50 too cheap - so 1.25-1.35 is my guess come 12 months from now. Within time the micro economy will take care of the macro mistakes.

Outlook
So the expected policy/expected outlook would in short be like this:

• This weekend: SNB introduces 'FX floor on the CHF'
• Next week: Bernanke goes all in on the Operation Twist and creates a small bear market rally (4th wave up, before 5th down)
• The start of funding pressure emerges

Then in two weeks time:

• The ECB goes full in on QE - Obama announces an FDR-light program about jobs and incentives (which he will have no political backing for).
• Labour day: Crisis 2.0 restarts and puts pressure on France to introduce serious measures. The EU Summit ends with no result (again) as politicians still think they have more time.

From Q4 on - Crisis 2.0
By Q4/Q1-2012: Everybody is now unhappy - Crisis 2.0 legitimises the final move into Eurobonds and a fiscal transfer union.

A Crisis 2.0 is needed to clear the political inability to get ahead of this crisis. Maybe the silver lining is the fact that the origin of the word Crisis from Greek is: Change - let's not hope it's the modern Greek version of crisis - i.e. buying time - that prevails!