Weekly Macro: One step closer to a meeting of the Cardinals?

We spent considerable time today discussing the "banking union" which seems to be the economists' and policy makers' favorite panacea for the EU debt crisis. Our conclusion is that we can't see why or how this will be the eventual solution.

We do see why the bank union idea is "appealing" from a political and an economist's point of view, but it is basically like trying to building a house with no foundation - and starting the buildilng process with a new roof so it won't rain on you!

Here is our take:

Upside:

1. Politicians, wrongly, think they can create a "European wide deposit insurance" and then move towards more integration.
2. Theoretically it should make depositors in Spain, Italy, Greece and Portugal more confident about keeping their money in local banks – again, theoretically.
3. Would be seen as one step closer to a true fiscal union.

Problems:

1. France, the Netherlands, Finland, Denmark, and the UK will not want to give up banking sovereignty. This is a pre-condition before they even arrive at the negotiating table. Also, having a EU-wide banking guarantee would mean there would be a European central authority that has domestic powers. It would challenge the current system of "national champion banks" and force serious adjustment by these banks.
2. EU Treaty - clearly any such change would need to be ratified by member Parliaments. This would be unlikely to find broad based support.
3. This is a bad way of trying to arrive at Fiscal Union through the back door
4. It fails to increase the solvency of the banks - what is needed is the Swedish banking rescue model, where the bad bank Securum was constructed to deal with bad debt from partly public owned banks. Ultimately, the Swedish state and its tax payers ended up making money on this solution! Again, if done as a pan-European solution, we would have to re-enter points # 1-3 as major reservations for the likelihood of this happening. But at least it would be a step towards dealing with the underlying solvency issue rather than simply providing liquidity.
5. It will not keep people from pulling their money out of Europe. The banking union needs to be credible, if it isn’t, the outflows will continue. Should the banking union only involve the Euro-zone, then I would personally deposit my money in Sweden, Denmark and Norway. If it is fully European – very unlikely – then we all need to move our money outside Europe as there is no guarantee that "throwing liquidity" at banks will help - look at policy makers’ action of the past three years!

The point that many people missed on the Spanish bank deal this weekend, was point #4, in addition to the implicit subordination of all Spanish bonds, and risk wise also BTP's, to the EFSF/ESM.

A banking union would be a further extend-and-pretend but of the worst kind: Merely trying to be reactive to the capital outflow from Southern Europe as opposed to addressing the structural changed Europe needs.

Solution

I am a very simply person/trader. I believe in integrity and simple plans. Europe needs to find its roots and the history of why we have an EU. The United State of Europe speech by Churchill in 1946 was an anti-dote to the forces that brought us the two world wars. The EU of 2012 is even exasperating the believers among us who want some EU, just not too much.

So my advice to EU leaders going into the EU Summit on June 27/28:

1. Stop pretending.
2. Scratch any idea of a banking union - deal with reality, not more extend-and-pretend fantasies.
3. Deal with solvency not liquidity - Read up on Securum. Note the link, once again!
4. Redefine what the EU is meant to be. Reverse all programs until there is multilateral acceptance of the very premises of the EU going forward.
5. Implement an EU law that no country after 2017 can run a primary deficit larger than 1% of GDP – no exceptions.
6. Accept that Germany is right and that the "growth people" do not know what they are talking about. Growth is not a policy it's a result and creating jobs comes from freeing the micro-economy not from concocting more macro policies in Brussels.
7. Shut down the European Council in Strasbourg as a token sign of realism and reduce the budget in Brussels by 70%. Less is more for the European voters.
8. Decide whether we want a fiscal union or not. When originally committing to the Euro single currency, countries signed on the dotted line of the Maastricht criteria. Now is the time to enforce it or leave it behind.
9. Create a plan with a maximum of five steps to move Europe forward. Not the usual rhetoric but simple steps - one page maximum.

Yes, expecting the above is totally unrealistic, but it won’t stop me from making the point that if the EU continues down the path it has trodden over the last five years it will mean that the EU leaders are well and truly insane. Einstein defined insanity as someone who: "Keeps repeating the experiment over and over again and expecting different results".

Conclusion
“Banking union” will be a buzz word. If it is implemented, it will not contain capital flight as even a 10% chance of losing your money if the EU breaks up is 9.99% too high. The one question I always get when I meet clients is: "Where should I put my money?" That clearly illustrates that we don’t need a banking union scheme, but a credible, long-term, and solvency-addressing solution.

Weekly Macro Main Points:

Data
Major developed markets continue to disappoint - Australia was the only positive exception and late in the week China was as well, but from very low levels. In our mean-reversion model of the US and global economy (the index moves from +100 to -100) we are presently at around -50 for most economies. This indicates that the worst of the erosion is behind us, and in some cases: 2006, 2008 and 2010 the indicator stopped falling around here, but generally the risk is all the way to -100. We see weaker data continuing for now, but are waiting for the doom-mongers to call for a double-dip recession to change to positive.

Our closer look at the US consumer confirms he/she is still spending money. Investment is slowing, but the ECRI still sees more than 50% chance of recession. (www.recessionalert.com)

Cross Asset Technical overview

Last week we had the biggest risk-off, negative view in the history of our Tuesday Macro meeting - and the market promptly unwound the excessive bearishness through the rally during last week. You can be right about macro, but sometimes micro takes over!

We see last week as being 90 per cent driven by this oversold status rather than any false belief in the success of the Spanish banking bail-out (Yes, Spain, it was a bail-out!). Weakness is still a risk, but going forward, new Fed QE could be a game changer. Sometimes one has to accept that the market needs both sides of the trade - nothing is ever a straight line up or down.

Yield and Credit overview
Higher yields across the swap and fixed income market based on specific and general moves. In Sweden, the FSA enforced an interest floor on pensions (trying to contain massive rally in bonds and consequent pressure on pension funds) which led Swedish rates over 10 bps higher on the 2-year and 30 bps higher for the 10-year during the week.

Sweden and SEK are fast becoming a refugee for the capital flight of Europe. This is a theme we had in our outrageous prediction 2012 - (Sweden and Norway to become the new Switzerland) - We are very bullish on SEK over the summer, despite the small open economy dynamics. Sweden is well managed - has some of Europe’s most solid banks (Svenska and Nordea) and has room for fiscal- and monetary movements.

In the yield space we once again note the pressure is on Italy and Spain, the EU too-big-to-fails. We also watch our 50 per cent long in corporate yield continue to perform okay.

Politics and Macro

We were all surprised at the shoddy management of Spanish government PR. How can you refuse to take English questions at a press conference when you’ve just received a bailout of EUR 100 billion?

And why do Spanish authorities constantly float ideas that have no Brussels- or German backing? Does this have more to do with Rajoy thinking about election promises rather than wanting to go through with this reform program? We are puzzled (it seems to be chronic, sorry).

Ms. Merkel is getting closer to decision time. I observe how she is increasingly talking and sounding more like former Chancellor Kohl - more about vision than details. I remember Chancellor Kohl once being asked by German TV in 1998: “Herr Kanzler - how are you getting the Germans to accept the new Euro?” After a long pause, Kohl replied: "Die Realitaten” [translation: reality or circumstances]" - enough said. The problem now is that Ms. Merkel and Sarkozy and their accomplices have made so many mistakes that have compounded into such a seemingly unsolvable mess. But watch the domestic German discussion as the ESM debate will need to take place on the Bundestag floor and in the Bundesrat before they go on holiday in early July.

Italy. We are on the alert for Monti to step down soon. His support is fading fast and it looks like we will have a late summer election, which would again increase the EU debt tail-risk.

Switzerland - the spread between 2 yr. Germany and 2 yr. Switzerland is now a negative 37 bps, with Swiss rates at the short end of the curve having turned outright negative. Capital controls are probably next and as I wrote yesterday: The single biggest trade/event risk in the market is probably EUR vs. CHF breaking the 1.2000 peg on an escalation of EU debt crisis. I wrote an extensive piece on this risk yesterday: CHF: Systemic risk and the EU debt crisis

FOMC preview. We discussed the different camps inside the FOMC. The dovish camp: Bernanke, Dudley and Yellen vs. the hawks represented mainly by Fisher.

We agreed the following. Using the Fed's own models, it is clear that the hawks have the 'bragging rights' presently. They can argue that the various potential Fed actions from here are better to do in more normal circumstances. Especially if they believe, as they should, that unemployment is structural not cyclical (Bernanke still apparently believes it is cyclical). However, the Taylor-rule based camp (Bernanke et al) want more monetary easing short-term to get us through to 2014 and normalisation. The bottom line is: It remains a 50/50 call next week. When in doubt, Bernanke has always “erred” to the (like Greenspan) easy side - we think there is more than a fair chance of FOMC extending Operation Twist - but hardly enough to please the liquidity driven Keynesian economists in the short term.

Event risks for the week ahead:

Today: Redbook(US)
Wednesday: US Retail Sales, New Zealand RBNZ interest rate decision
Thursday: Switzerland: SNB Monetary policy assessment
Week-end: Greece election and French Senate election.

Strategy:
Still the same portfolio since Q4-2011: 50% in High corporate bonds, 25% in cash and 25% in tail-risk options (Long GDX (Gold Miners ETF), Long stock market puts, Long German Bunds) Currencies: 50% in US dollar, 25% in SEK and 25% in NOK.
This stance has served us well and we’ll remain with this portfolio until the tail-risk disappears or at least get far smaller.

Conclusion
Politically we feel/think we are getting closer to "The Meeting of the Cardinals" in Europe. The EU needs to make a lot of better decisions to get us out of this negative, tail-risk oriented market and it is difficult to see the path ahead for the EU. The only path taken so far has been: Extend-and-Pretend leading to Japanisation.

We remain focused on the major tail-risks:

1. Spain and Italy default risks “in play” again
2. Potential failure at EU Summit to find roadmap to fiscal union
3. Greek election
4. Lack of credit: shortage of Euros and US Dollars in the interbank system.
5. Lack of solvency in banking globally.

Safe travels,
Steen Jakobsen