European House of Cards, Follow the Money

By: John_Handbury

You’ve got to give super Mario Draghi his due – he’s no dummy.  His comments in July "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough", were just in time to reduce the yields on Italian and Spanish bonds for their major issues the next week.

The ECB has now cleared the hurdles to launch a new round of short-term bond (note) buying of PIIGS debt, the “S” being Spain, the most worrisome nation for now.  The newest acronym-du-jour is Outright Monetary Transaction (OMT) plan.  So, despite the fact the first round of ECB bond-buying didn’t have any impact on yields, the idea is that according to Keynesian Economics 101, the buying pressure will lower their yields, thereby increasing their price.  This is surely not to help Spain, which has already financed until the end of the year.  However, the idea is to increase the value of the mountain of sovereign debt owned by the European banks and governments (and the ECB) and get them out of the insolvent mess they are in.

However, there’s one catch: there’s no Spanish bonds to buy.  The Spanish bond market, including the repo market, is completely dysfunctional.  No one is selling Spanish bonds for the following reasons:

• Spain has already financed its debt until the end of the year so it doesn’t need to sell any more bonds
• The banks can’t sell their huge inventory of bonds at these low price levels since they’d have to declare the losses from collateral, which they can’t afford.  They are already overstressed from the persistent migration of capital out of Spain.

Due to a clause in the Treaty on the Functioning of the European Union (TFEU), the debt purchases will be done in the secondary (repo) market. Here the only source of sovereign debt is short-covering from traders who are already long.  Lately to cover these long positions traders are having to pay a premium of up to 4% to unload their positions, which is completely opposite to a normal repo operation.  In other words, borrowers are effectively being paid to take the lenders money.  This is completely dysfunctional.  According to Elaine Lin, a strategist at Morgan Stanley "On the whole the repo market in Spain has deteriorated much faster with the Spanish markets under pressure. You need the sovereign market to be more liquid".

So if the ECB, armed with billions of printed euros, will go on a buying spree and will find there’s very few sellers.  Their attempts to buy more bonds at any cost will only make the market more dysfunctional.

The ECB bond purchases will be “sterilized”, which means the ECB will draw out an equal amount of money (paying interest) that they are injecting into the economy.  The intended purpose of this is to negate any inflationary effects.  Below is the incestuous loop that will likely result from this sterilized bond-buying program:

It appears that Draghi et al are building a house of cards that can only result in collapse on the first breath of wind.

John Handbury
Independent Trader
johnhandbury@hotmail.com

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