I got it, I got it! What is it?

Late last night (actually really early this morning) as everyone knows by now, Europe “solved” the Greek debt crisis.   According to Reuters:

Euro zone leaders struck a deal with private banks and insurers on Thursday for them to accept a 50 percent loss on holdings of Greek government bonds as part of a plan to lower Greece's debt burden and try to contain the two-year-old euro zone crisis.

In an agreement reached after more than eight hours of sometimes harsh negotiations, the private sector said it would voluntarily accept a nominal 50 percent cut in its investments to reduce Greece's debt burden by 100 billion euros, cutting its debts to 120 percent of GDP by 2020, from 160 percent now.

At the same time, the euro zone will offer "credit enhancements" or sweeteners to the private sector totaling 30 billion euros. The aim is to complete negotiations on the package by the end of the year, so that Greece has a full, second financial aid program in place before 2012.

The value of that package, EU sources said, would be 130 billion euros — up from 109 billion euros when a deal was last struck in July, an agreement that subsequently unraveled.

"The summit allowed us to adopt the components of a global response, of an ambitious response, of a credible response to the crisis that is sweeping across the euro zone," French President Nicolas Sarkozy told reporters afterwards.

The stock market rallied strongly on this, pushing the monthly gain for the S&P 500 to its highest level since 1987.   We expected this rally, and expect continued market strength in over-sold sectors, although the overall market will probably fade a bit here.  However, those who understand how the markets work in Europe don’t think this is a permanent solution – just like the first Greek “solution” over 2 years ago wasn’t the solution either.  But it works now, and we’re in the here and now business, not the “ivory tower what’s right” business.   This is a big move and the markets are working off of a big oversold condition last month.   Our long call starting October 5th was about as good as it gets, but its nearing time to tip the man and go home.    

Quoting our trader at Goldman, Sachs: 



We are not rallying because Europe “got done.” It didn't. We are rallying because the market wants to rally. After 6 months of pain and lack of direction, investors need to cheer on something and what better reason to cheer than headlines which seemingly tackle the scariest of all global problems - the one of disintegration of the second biggest Monetary Union in the world.   As a colleague noted, why be contrarian when:

• realistically there is one month of trading left
• most trading strategies seem to be flat at best year to date, so few bears seem to have the risk appetite to "call" the market in here
• there are still a lot of crowded shorts/hedges out there
• it seems like politicians just solved the biggest macro issue at least through year-end 

It simply doesn't pay to take the other side of this rally for the time being even though most probably one should.

The problem is that the deal struck doesn’t solve the problem at all.  First, the details are wildly unknown.   The haircut on private debt hasn’t yet been agreed to by those taking the actual losses, the structure of the credit enhancements isn’t done, and the details of how to actually swap the bonds weren’t even discussed yet.  For a good discussion of the issues, read this Financial Time article.

But the real problem, and why this deal won’t work, is that the EFSF cannot fix the problem.   The European Central Bank (ECB) needs to print money to buy (effectively monetize) the debt and absorb the losses.   But the German’s don’t like printing money, as they are deathly afraid of runaway inflation.   (See my note tomorrow on the Germans and the Weimar inflationary period after WWI).  So we are stuck playing the game of kick the can down the road – a fun game as a kid, but not so much when dealing with a sovereign debt crisis.   Simply put, the EFSF is like New York and New Jersey lending money to a bailout fund (i.e., the EFSF) that will then lend to California.   All it does is move the bad paper from one holder to another.  It's as if all the US states got over leveraged, and so they all got together to fund each other – it makes no sense.  To clarify, the ECB (i.e., our Federal Reserve) is needed because it can simply print money and absorb unlimited losses, while the EFSF nominally needs funding from other countries, and won’t be able to sustain another country defaulting, like Italy.  So having a limited amount of firepower means that it is likely to be needed and will prove to be too small in the end. 

For a good summary of why this deal won’t work, please click here for a summary from Warren Mosler of Mosler Economics.