Monday, 12 September 2011

Weekly Commentary on Financial Markets: 12 September 2011: Risk of Policy Mistakes Rising – Europe Quo vadis?

Weekly Commentary on Financial Markets:  12 September 2011
by Jacob H Schmidt

Risk of Policy Mistakes Rising – Europe Quo vadis?    
News of the week: SNB pegging CHF to Euro, promising to defend 1.2 level; USD, Sterling and Euro rates unchanged; Greece close to default
The discussion of the future of Europe and the Euro intensified last week: banks under pressure from their exposure to Greece and other PIIGS, no progress on the Greece PSI (Private Sector Involvement, a PC term for restructuring) and a terrible Greek GBP (-7% in Q2) lead to a sharp reversal of the short term good mood in the markets. Pressure on Italian bonds: without ECB support yields would be substantially higher than the 5% level. We estimate real yields on this high yielder should be closer to double digit, as around the last BTP auction the ECB bought more bonds in the secondary market than Italy placed in the primary. Trichet’s portfolio is now massive and the operations have to continue, otherwise the market in BTPs would collapse. Our outlook for the Euro, Greek GGBs and other Govies is very negative. Eurobonds / EU treasuries issues unlikely to happen here. My Grade: C-
In Germany Merkel has to tread very carefully between a pro European / EU course and the growing critique of the EU, ECB and debt situation. While some politicians like former chancellor Schroeder believe that the Euro has to be saved at any cost  and leadership is required to move closer together, the opposition in Germany is growing. In the recent elections Merkel lost key support. While many argue that the German export sector needs the EU and the Euro, and Germany wants to show leadership as a stable partner in Europe, we believe that the support for a debt laden Europe pulling Germany down is slowly shrinking. It is unlikely that Germany will pull the plug any time soon, i.e. leave the Euro, or force Greece to leave, but it is possible that she will stop providing unlimited support for the debt hungry PIIGS. If Germany is to continue its financial support, then with more influence rather than less. With the resignation of Juergen Stark on Friday Germany lost another key player on the ECB board: both Axel Weber who resigned in spring and Stark were considered hawks, but in reality in the school of the Bundesbank. The appointment of Joerg Asmussen, a SPD man, represents an interesting development:  is Merkel planning a broader political base, i.e. grand coalition or is Germany just short of senior bankers / central bankers? Tricky developments. My Grade: C
The ECB is in a serious situation: a huge portfolio of PIIGs bonds, rates too high, Stark’s resignation, and the future of the Euro questioned. Trichet appeared really upset at last week’s press conference, lost almost his countenance. As he is to leave in a bit more than 2 months he is half way out, but keen to protect his reputation and heritage. It is unlikely that he will be in power when Greece defaults, when the portfolio and the Euro will get into serious trouble. He might suffer a similar fate to Greenspan after his departure. The ECB desperately needs the EFSF to continue and increase the bond purchase program and a debt deal (the PSI) with Greece. All increasingly unlikely. My Grade: C
Bernanke confirmed his zero rate Fed funds policy, but kept short of details regarding a QE3, actually waiting for Obama to do the job.  In his long awaited speech President Obama unveiled a massive USD 420 b job program, which the market did not like. I believe there is a good chance still, that we will see some form of QE3 in the next few months. The FED has no other tools, apart from announcements. Nevertheless the Fed and US look like a rock of stability compared to the EU and the ECB. My Grade: B+
In another move to defend the CHF the SNB announced the peg of the CHF to the Euro at the 1.2 level (Euro / CHF). After the operations in the FX Swap market in August which drove rates to negative, the pegging is even more drastic. We believe that this move is a serious policy mistake. The alternatives of no intervention (painful for the economy), FX controls or fees for FX transactions are preferable in our opinion. A peg to the Euro (a weak FX) is actually counterproductive as the logic of CHF strength is the flight to safety. This promise of indefinite and unlimited defence can become very expensive and ultimately ineffective, see the UK in 1992.  My grade: C-
Greece: 1 Y Greek bonds now trading at 50% yields. There are rumours of an imminent default, rejected by the Greek FM on Friday. The situation is so serious that we believe that this could be a repeat of 2008 Lehman. Greece is accusing speculators, demonstrations in Athens, and the PSI faltering. My grade: D
Commodity markets (Gold and Silver) volatile during last week, Gold again at an all time high of 1910 before selling off sharply to below 1800. Crude and industrial metals also volatile and driven by investors and black boxes. Gold very expensive, but has safety aspects. My grade: B+
Equity markets in US and Europe very volatile, short aggressive rallies followed by sharp corrections. Bank stocks are the major casualties, both in the US and Europe, despite the short selling ban. A Greek default would be very negative for the banks (mainly Greek banks and the ECB), but the other respective countries (Germany, France et al) would certainly support their banks, hence a banking crisis unlikely to spread throughout Europe. The risk is a contagion to Italy and Spain. My grade: C-
Hedge Funds:
Very interesting markets for hedge funds: at least 50% disappoint, but the rest offer interesting performance and diversification aspects. In the pending court case of Weavering (blow up in 2009) the SFO dropped its probe against the fund manager while a court in the Cayman Islands fined the two independent directors (being the brother and step father of the London based fund manager) $111m for wilful negligence or default. Very confusing for outsider, very bad for Weavering investors. SFO move difficult to understand. Lesson: due diligence before and during investment cannot be substituted or saved. My grade: B-
News of riots in Egypt and attack on the Israeli embassy sad, posing additional political risks. My grade: B-
Like last week: risk on – risk off. Bond Yields in US and Germany now under 2%, German Bund yields at 1.77%. Stock markets, FX and commodities all extremely volatile, with risk of decrease in market liquidity.
Decisive times in politics and markets, but no clear strategy out of EU. We are concerned that policy makers will make further serious mistakes (Greece, PSI, Euro, CHF, debt profile, short selling ban et al) with far reaching implications. Hence markets will continue to be extremely volatile until a solution / plan is in sight, which is unlikely.  We see short term fixes, leading to short term rallies only. Serious risks not be underestimated.  
We recommend our clients to be very cautious in their investment and trading activities in the next few weeks, until a clearer pattern for the big issues, the future of the Euro and the debt of the PIIGS, emerges. Patience is a virtue.
Jacob H Schmidt, international financial markets expert, HF expert, Webster Finance Professor. Anglo- Austrian, multi-lingual,-cultural, critical thinker. CEO of Schmidt Research Partners Ltd, an investment advisory firm and MD of SFP-International Ltd, a consulting and training company. Available for high quality investment advisory, due diligence and consulting projects.  
Schmidt Research Partners are expert providers of advisory services, due diligence, research, consulting and training in financial markets.
This commentary is for information only. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be solely relied on in making an investment or other decision. It is not an invitation to buy, sell or subscribe and is by way of information only.

Jacob H Schmidt
CEO, Schmidt Research Partners Ltd
Director, SFP-International Ltd.
Adj. Professor, Derivatives and Investments, Webster University London
36 Seymour Street, London W1H 7JF, UK

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