IN-CREDIBLE! (Edit 1)

As in not credible, as opposed to wonderful.  European leaders' latest ploy is to have us believe that they are going to lay the groundwork for a Treaty change that will enforce fiscal discipline throughout the Eurozone.  This time they are SERIOUS, as opposed to when the approved the same provisions in the Maastricht Treaty a decade ago.  This time, offenders will be automatically penalized.  Any nation which cannot get its deficit under control will owe yet more money in fines, enforceable by ??.  Furthermore, all governments will have to have balanced budgets (at least until the next crisis....)

Now, based on these new "pinky promises," the consensus view is that the ECB will step in very aggressively to set a ceiling on Italian and Spanish yields.  The logic is obvious and compelling - how could the ECB just sit there and preside over its own demise, right?  The fact that such a move would likely be illegal, would jeopardize the credibility of the ECB, and would establish tremendous moral hazard is discounted.  "It's not pretty, but it's got to be better than letting the Eurozone go under, right?"  From what we have seen so far in the negotiations over Greek debt, bonds held by the ECB would likely be senior debt, with private sector held bonds being immediately subordinated.  Oh, I forgot, the EU leaders also pinky promise that the private sector will no longer be at risk in any default scenario.  "Don't worry!  We'll be happy to have our domestic taxpayers absorb the losses on that foreign debt.  Seriously!"  (Edit:  BTW, if the ECB chooses to go down this path, it needs to go all in right up front.  Otherwise, the market will test its resolve.)

However, we won't stop there.  Leaders also hatching a scheme to bring forward the implementation of the permanent European Stability Mechanism (ESM).  The EFSF is failing rather miserably, is at great risk of a ratings downgrade, and is also ineligible for direct loans from the IMF (as it is a Luxembourg based corporation).  The ESM, on the other hand, would be eligible for IMF loans.  In contrast to the EFSF, which is funded based on promises (callable capital), the ESM will require that Eurozone countries actually start ponying up real money.  This has been floated before, but, like any good, self-respecting TURD, has risen to the top of the bowl again.  I discussed this very idea on October 23rd, and I will reprint my comments here.

"A final scatalogical remark, regarding the dog and pony show to rescue the Euro. The market rallied on Friday because someone suggested that the European Stability Mechanism (ESM) could be brought forward and combined with the European Financial Stability Fund (EFSF). As you (should) know, the EFSF is the temporary measure with 440 billion of lending capacity and funding via callable capital guarantees. The ESM is the permanent mechanism that was to replace the EFSF in 2013, and would have 500 billion of lending capacity funded by paid-in capital. It is quite clear from the ESM Treaty that the ESM was never supposed to be additive to the EFSF, as you can read below:

TRANSITIONAL ARRANGEMENTS

ARTICLE 34

Relation with EFSF lending

During the transitional phase spanning the period from June 2013 until the complete run-down of the EFSF, the consolidated ESM and EFSF lending shall not exceed EUR 500 000 million, without prejudice to the regular review of the adequacy of the maximum lending volume in accordance with Article 10. The Board of Directors shall adopt detailed guidelines on the calculation of the forward commitment capacity to ensure that the consolidated lending ceiling is not breached.

__________________________________________________________________________________

Changing this restriction to make the two programs additive would:

1. Require approval in all 17 Parliaments again (ain't happening)

2. Nearly double the budgetary bailout commitments of Eurozone sovereigns, to include Italy, Portugal/Ireland (which do not pay into the EFSF, but are slated to contribute to the ESM), and FRANCE!

3. If combined with a 50+% haircut on Greek debt and a substantive government funded bank recapitalization, could be enough to cost France its AAA."

The only real differences between when I made those remarks and the present are: 

1. Many more nations than just France are at risk of losing their AAA.  These ranks now include Germany and Holland.  France itself looks more like a two-notcher.
2. Italy and Spain look even less likely to be able to contribute actual money to the ESM.
3. The Greek haircut is going to be well over 50%.  In fact, I think the private sector holders are going to get wiped out, zero, bupkis.

Let's see, what else?  We also have talk of the IMF coming in to provide emergency funds to the Eurozone.  Remember, the IMF loans money to governments, government entities, and national central banks.  They do not buy bonds, and any loans they make are super senior debt.  But, the real problem is that the IMF does not have enough money to amount to much more than "chump change" (h/t Stephen Roach, MS) viz-a-viz the amounts of sovereign debt that need to be backstopped.  Of course, there is talk of the ECB somehow loaning the money to the IMF to increase its firepower.  Even the Fed was mentioned as a possible participant in funding the IMF, although Geithner denied that today.  As far as I know, the USA's latest pledge to the IMF has not actually been funded by Congress, which should be quite the circus to watch if we go down that particular road.

Whatever the case, I would summarize the situation as follows:  European leaders are making incredulous promises regarding financial discipline in order to draw supra-national funding.  Any supra-national funding source that does contribute is going to have super senior status, regardless of any promises to private sector bond holders (see here).  Looks to me like a great opportunity for private sector bond holders to unload...

As to markets, we are obviously not in (3) of [C].  My count has us now in Minor Z of Intermediate (2).  I'll illustrate with the DAX and the RUT.

DAX:  The 10 minute chart gives a projection.  It presumes that a five wave [a] of Z has concluded, and that [b] is in progress.  Support for [b] is strong at the .50 retrace of [a], near 5760.  Assuming a rebound from ~5760, [c] would be equal to [a] very near the .618 retrace of Intermediate (1), around 6550.  That would mark the top of (2).

DAX DAILY

DAX 60 MIN

DAX 10 MIN

RUT:  Again, the 10 minute chart tells the story.  A five wave [a] of Z is over, [b] should find lateral support around the .382 retrace of [a], around 717.x.  From there, [c] would be .618 of [a] around 779, which would also be the .618 retrace of (1).  However, this is sort of no-man's land as far as lateral resistance.  [c] would equal [a] at ~809, which would be more like the .786 retrace of (1), and a much more promising lateral resistance level.

RUT DAILY

RUT 60 MIN

RUT 10 MIN

The obvious fly in the ointment with either of these counts is that they put the DJI at great risk of making a new recovery high, particularly if the RUT makes it all of the way to 809.  So, maybe we see less rebound than I am projecting - Z does NOT have to exceed Y in (2).  Alternatively, I could just be completely wrong about the longer term count.  Wouldn't be the first time...


Recommended Read:  Moral hazard will result from ECB bond buying (Otmar Issing the FT)  A much more nuanced article than the lousy title suggests.  Contrasts the legitimate role of a central bank as a lender of last resort with the very dangerous role of being the ultimate buyer of sovereign debt.


EDIT:  Another Recommended Read:  Winning the European Confidence Game  (Raj Rajan)  An excellent discussion of the lack of loss bearing capacity of supranational funding, be it from the ECB or the IMF.