Sunday, November 27, 2011

The Largest Threats To Investors on the Immediate Horizon

The following note from JPM’s Ken Landon summarizes what, in the aftermath of an ECB which as Yves Mersch just noted, will not intervene in the markets due to the realization that monetization will bring about the 4 horsemen of the apocalypse, is the greatest threat to investors: strong>political instability, manifested either formally in the form of elections, or informally, in the form of occupations, riots, revolutions, civil wars, alien invasions, etc. And of course, to JPM (NYSE:JPM), just like to everyone else threatened by the upcoming end of the status quo, the bad guy suddenly is the ECB, which had made it all too clear since inception it will not monetize debt. Yet somehow now that we are approaching the endgame it appears this was not very clear. So the plan is to shame them into monetizing everything, Weimar flashbacks be damned.

To wit: “The ECB does not operate in a political vacuum. It is the only entity that has the capacity to be the lender of last resort in the Eurozone. Without this, the Eurozone does not have much longer to exist. It will implode. With the ECB decidedly on the sideline, investors are reduced to the state of having to read the tea leaves of national politics. For example, today and tomorrow are crucial days for the formation of the Monti-led government in Italy. Will he be given a strong mandate? Even if he is, will the new government be able to come up with a credible plan that investors will have confidence in?… Greece remains a wild card with the main opposition party refusing to sign a declaration of support of the October agreement.? When politics dominate markets and economies, you can be sure that uncertainty will reign and that growth will suffer.” So without further ado, here is the complete list of what to look for in the next several months on the all too critical political front, courtesy of UBS (NYSE:UBS).

And the full note from JPM:

Is ECB Waiting For A Panic Before Acting?

* ECB – Although most attention is focused on the actions of national governments in Italy and Greece, the key to near- and medium-term developments is the ECB. This has been a theme of the Lowdown for months. That is, the Eurozone is dysfunctional because it is a giant Social Welfare State without all the means of financing the required spending. A captive central bank is a crucial entity for the financing of governments. The common phrase “lender of last resort” is most applicable to governments that investors have judged to be too risky to lend to. That is where central banks come in very handy for governments. When no one else is willing to lend, most governments can turn to their captive central banks, which have the power of unlimited finance because of the ability to “print” money (or to create unlimited amounts of bank reserves).

This is the key issue right now. The Europeans set up a system in which its central bank would supposedly refrain from financing any particular government. Of course, this legal restriction on the ECB was broken in spirit when the ECB provided repo financing to banks on favorable terms. Regulations that favor government debt made it inevitable that the banks would buy the least risky asset with the repo financing. They loaded up on government bonds and, thus, the respective governments were financed indirectly by the ECB.

As a result of the monetary and regulatory restrictions, European banks now find themselves in a weakened position. In other words, the financing conduit of government finance has been shut down in Europe, which leaves just one bank — the ECB — that could provide funds. Instead of acting as a traditional lender of last resort like most central banks around the world do, the ECB is sitting on its hands and claiming that the problem is for governments to resolve.

I agree with the ECB.? The fundamental problem is for governments to r! esolve. Despite widespread public opposition to the trimming of the giant Social Welfare State, governments have to find a way to cut spending. Otherwise, the current system is unsustainable and will collapse in on itself.

As much as I agree with the ECB about the fundamental issue, I disagree with the central bank’s aloofness when it comes to government finance. The ECB does not operate in a political vacuum. It is the only entity that has the capacity to be the lender of last resort in the Eurozone. Without this, the Eurozone does not have much longer to exist. It will implode.

* With the ECB decidedly on the sideline, investors are reduced to the state of having to read the tea leaves of national politics. For example, today and tomorrow are crucial days for the formation of the Monti-led government in Italy. Will he be given a strong mandate? Even if he is, will the new government be able to come up with a credible plan that investors will have confidence in? At the time of writing, the surge of Italian 10Y yields to above 7% suggests that investors do not have confidence at all. Greece remains a wild card with the main opposition party refusing to sign a declaration of support of the October agreement.? When politics dominate markets and economies, you can be sure that uncertainty will reign and that growth will suffer.

There is not much more to say. Investors and economic decision-makers are being paralyzed by the political uncertainty, which will be with us for quite a long time. Keep in mind that political uncertainty remains in the U.S., although the nightmare in Europe has taken attention away from Washington. Next week, the so-called Super Committee is scheduled to release its proposal to cut the fiscal deficit. As of writing, it is unclear if Republicans and Democrats have been able to agree to a credible plan.

In this environment, the JPY will continue to perform well because it is now the default “safe haven” currency. To e! nd on a less pessimistic note, gold is the ultimate protection asset. The supply of gold is not subject to the whim of policymakers, which makes it an excellent store of value. It is notable that gold has not come close to challenging the previous high of just above $1900 that was hit in September. Perhaps that is telling us that the world is not as messed up as the headlines make it appear? Or perhaps that is merely a reflection of positioning in the market? However, the longer that gold remains below its previous high, the more credible its signal will be that the financial system is not as weak as many people currently fear.

Tyler Durden is the author of Zero Hedge.

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