May 21, 2010

Wanna make money...? go long equity/short gold

We're witnessing historic times.. Just 18 months after the largest financial crisis since the Great Depression, speculators around the world are playing yet another end-of-world game.. and a game with higher stakes.

Here's what's happening.. Short Euro, Long Credit Default Swaps of the UK, France, PIIGS.. eventually the US and Japan. Short risk assets, move money into dollars.. but people are worried about the debt situation in the US as well so the natural end of world trade commodity - gold - should go up. These trades will payoff if the Euro collapses..and if it does, then one can move to other OECD sovereigns and play the same game. Greek, small as it may be, has become the unfortunate playground for the clash between Central Banks and Speculators.

Greek, which should ideally have been allowed to restructure its debt, can't be let to do that as the European banking system will then need to be bailed out. Fixed Income desks around Europe have been in the convergence trade since after the institution of the Euro - they go long high yielding bonds from countries such as the PIIGS and short the bunds to earn the spread (assumption was that credit risk of all euro countries is equal).. If the Greeks restructure their debt, banks in the Euro zone will have to take large hits on their bond portfolio which contribute towards their Capital Adequacy Ratio.. They will then need to be bailed out/recapitalized by the public sector. Markets will freeze and we'll see an uglier version of 2008 banking crisis as contagion will spread to other asset classes. In short, to avoid a really large, potentially unmanageable, bailout of the entire Anglo-Saxon financial system, private mark downs on Greek government debt needs to be avoided.

The reasons why I think the Central Banks can win this war against speculators on the currency front are simple
  • they've got infinite capital (they can print), and they don't care about MTM. The P/L is not their target, nor is their compensation linked to the P/L
  • they understand the stakes and they have the legal powers (which was not the case when the US authorities had to let Lehman go.. they understood the stakes but did not have the legal authority to save Lehman)

For the Central Banks and Governments to win against the speculators to win against the speculators, in addition to the interventions, they also need to cut debt to inspire market confidence in the longer term. Unfortuantely, the incentives created by the electoral cycle are misaligned with the economic cycle; cutting salaries now tends to cause governments to lose support while the sops associated with higher debts normally bring in more votes.

The immediate downside risk to global financial markets right now is not economic or financial activity;its political instability in Greece. If Greece decends into political and civil chaos, all bets are off. Best thing to do would be to wait till things settle down. If not, go as levered long as you can on equities for a really rapid 5% gain (and a 5% fall in gold)...

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