The Gray Swan Potential
An excerpt of a recent missive by Ray Dalio of Bridgewater was presented at Zerohedge yesterday. We have read the paper, but the salient point is in fact contained in the brief summary that discusses the probability that Germany won't 'blink at the last minute' and that the ECB won't suddenly discover its 'QE' printing press. Dalio concludes that in light of all this one should prepare for a 'fat tail' event – or in other words, a 'gray swan'.
Generally a 'gray swan' is considered a catastrophic financial market convulsion, a mass-correlated hyper-volatility event similar to the crash of 2008. A defining characteristic of the 'gray swan' is that it does not drop in on market participants out of the blue like the 1987 crash did (that was a 'black swan'). Rather, it is a foreseeable crash – the 2008 crash certainly qualifies as a gray swan in that sense.
Japan's mountain of fiscal debt is probably one of the world's biggest gray swans in waiting, but it's been such a long wait that no-one is thinking about it much anymore (which is to say, it is a gray swan that is getting slightly darker as time goes on). The euro area's debt crisis definitely has more imminent gray swan potential.
We are frequently struck by the fact that quite a few market observers in the Anglo-sphere don't really believe it is possible. For all the predictions of imminent doom (see Nouriel Roubini's latest dooming and glooming as an example), deep down nobody thinks it is going to happen. When push comes to shove, so the generally held view, then 'Germany will relent', or 'the ECB will print'.
But what if they don't, and why is everybody so sure of this? Dalio makes an important point about the ECB, which we briefly mentioned yesterday as well – namely, that its governing board is also split into major factions. Nothing will get done that has not the overwhelming support of all of them. Moreover – and this is our opinion, not a point specifically mentioned by Dalio – the ECB's governing council will simply not do anything that could be interpreted as a breach of the central bank's statutes.
Mario Draghi himself has made that crystal-clear not on one, but on several occasions. He even went as far as insisting that it is not the merely the letter of the law, but the spirit of the law that is to be adhered to. In short, don't expect any 'clever legal tricks' from the ECB. This does not mean that the ECB has fully deployed its interventionist tools just yet. There is conceivably a lot more it can do (more on that below) – but what it cannot do and won't do, is Fed or BoE-style 'QE'.
There is no mileage for bureaucrats employed by a supranational entity to stick their necks out too far, since they may be held liable if things go wrong. There would likely be forgiveness if things were to work out fine, but who can guarantee such an outcome? In fact our personal opinion is that the 'inflation solution' would in the end produce an even bigger catastrophe.
Then there is of course Germany – the supposed fount of magical solutions, held to be currently deploying itself erroneously as a roadblock. As the umpteenth (actually, it is the 19th, to be precise) euro-group summit approaches, Angela Merkel has been doing what we have told our readers some time ago leading German politicians always do ahead of these summits – she's been lowering expectations. Only this time, she has been doing so even more forcefully than usual. The most colorful of these events was her meeting with the intensely bailout-skeptical members of her government's junior coalition partner, the FDP. Here is what she said and what they replied:
“But on Tuesday, ahead of the crucial European Union summit in Brussels on Thursday and Friday, she was clearer than ever in her rejection of debt sharing across the common currency area. During a meeting with parliamentarians from the Free Democratic Party (FDP), her junior coalition partner,she said there would be no full debt sharing "as long as I live."
[…] several FDP lawmakers responded by saying: "We wish you a long life."
(emphasis added)
Nothing we have heard or read over the past few weeks encapsulates the German stance more clearly or concisely. If she had said 'no debt sharing until the end of the universe', they would all have wished for the the universe to continue for many unperturbed eons.
In parliament, she also found very clear words, to the warm applause of at least her conservative supporters. Her speech in parliament was evidently held after she had read the summit blueprint developed by Messrs. Herman van Rumpoy, Manuel Barroso, Jean-Claude Juncker and Mario Draghi, which can be seen here (pdf).
“In a statement to Germany's lower house of parliament, the Bundestag, Merkel made clear that she will not bow to intense international pressure on Germany to agree to joint bond issues that would calm the euro crisis by stabilizing ailing euro-zone member states like Italy and Spain.
She said the blueprint for closer financial integration drafted by European Council President Herman Van Rompuy, European Commission President Jose Manuel Barroso, Euro Group President Jean-Claude Juncker and European Central Bank President Mario Draghi contained major shortcomings, and that she would seek support for her own ideas in Brussels.
"I profoundly disagree with the stance taken in the report that precedence is given to mutualization, and that more control and enforcable commitments take second place and are phrased in very imprecise terms," said Merkel, to applause from conservative parliamentarians.
"There is a clear discrepancy between liability and control in this report, so I fear that the summit will once again talk too much about all kinds of ideas for possible joint liability, and much too little about improved controls and structural measures."
She said instruments such as euro bonds, short-term euro bills and a common debt repayment fund would be in breach of the German constitution in any case, and that she regarded them as "economically wrong and counterproductive."
[…]
In a clear signal to international partners to tone down their demands, Merkel said Germany's economic strength has its limits and that its scope to bail out other nations must not be overestimated. "Germany is the economic motor and anchor of stability in Europe but even Germany's strength isn't endless," she said.
Merkel, who on Tuesday declared that Europe would not share debt liability "as long as I live," repeatedly stressed her opposition to euro bonds, saying: "The mistakes of the past must not be repeated. Politically enforcing equal interest rates after they didn't work well in markets would be repeating an old mistake."
She said she would push for the summit to agree to a timetable and a working method to decide on reforms of the euro's architecture. "Our work must convince those who have lost confidence in the euro zone, not by self-deception and sham solutions but by fighting the causes of the crisis," she said.
(emphasis added)
When Americans read something like this, they may often wrongly believe that she is merely placating her domestic audience. In part, she is of course – but the above is also reflecting what she has come to believe. Flip-flopping is not as common in German politics as seems to be widely assumed.
Allow us to repeat the decisive passages above with regards to debt mutualization:
It is 'against the German constitution', it is 'economically wrong and counterproductive', there will be 'no political enforcement of equal interest rates', and what is needed is 'fighting the causes of the crisis, instead of adopting sham solutions'.
First of all, the part about the constitutional obstacle is really all one needs to know, but secondly, what is there in Mrs. Merkel's opinion and assessment of the fundamental economic situation and the associated incentives that anyone could possibly disagree with?
However, there is so much dissension now in the ranks of the euro-group that a clear course probably won't be agreed to at the summit. We actually believe that if the German ideas – intensive structural reform coupled with strict control and enforceable commitments – were to be adopted unanimously and then quickly put into practice, the markets would become a lot less jittery. The problem is not necessarily that the German course is 'too strict', the problem is the lack of unanimity regarding the way forward and the slowness and uncertainty attending the ratification and implementation of agreements.
This is why dangerous looking charts like the ones below must give us pause.
Spain's 10 year government bond yield has broken out. The last two breakouts were followed by swift retracements – and with the exception of the November 2010 breakout that was the case with every initialbreakout attempt. And yet, here we are, nearly at new highs - click chart for better resolution.
5 year CDS on Spain's sovereign debt (green line) are far above their previous highs already. Italy's have not yet bested their previous highs, but are perilously close to doing so as well. Greece (yellow line) is apparently about to go bankrupt for the second time - click chart for better resolution.
Below we show two charts – the S&P 500 index and the strongest major stock market index in the euro area, the German DAX. What is noteworthy is the divergence between them (a higher high in the SPX versus a lower high in the DAX) and the fact that the most recent decline from the highs has taken the shape of an impulse wave.
These divergences and the fractal shape of the initial declines at the very least spell 'danger'. It is always possible for divergences to disappear again and impulse waves can also appear in corrective structures. Still, this time the DAX has failed to appreciate noticeably in spite of a sharp decline in the euro. This is a marked difference from the aftermath of the market upheaval in the summer of 2010, after which the DAX climbed quickly to new highs for the move as the weak euro provided a tail wind for the shares of German exporters.
There are never any guarantees for specific market outcomes. Given the low expectations attending the summit, it is not inconceivable that almost any kind of agreement – even an obviously insufficient one – may become a trigger for a short term relief rally. On the other hand, it is precisely when divergences like the ones shown below are in place that the scene is potentially set for extreme outcomes in the other direction.
First the S&P 500 … - click chart for better resolution.
And here the German DAX for comparison purposes - click chart for better resolution.
