So S&P has downgraded a gaggle of European countries’ sovereign debt ratings. What a surprise. Ratings agencies are not always the last to know, but they are always and everywhere a tad slow.

Fundamentally, Europe is in big trouble. A good number of the countries are cash flow insolvent. Their banks are insolvent. These countries are now expected to operate austerity measures in order to regain their solvency, a task diametrically opposed to their task of regaining cash flow solvency. Tax revenue is correlated with economic activity and austerity is a drag on growth and hence tax revenue.

Basically the situation is as follows. A chap is being told by his bank to cut his debt. ‘But I need credit lines to run my business’, he says. ‘But you’re cash flow insolvent’, says the bank. ‘But I can’t do that at the rates of interest you’re charging me’, he says. ‘But we can only lower interest rates if you reduce your debt’, says the bank. ‘But I can only reduce it if you lower your interest rates’, he says. And round and round it goes.

The conversation the bank should be having with the customer is as follows. ‘How do you propose to repay us given that you are cash flow insolvent?’ The borrower gives some lame excuse. The bank then lays upon the borrower a plan of reorganization that involves selling some assets, cutting costs, laying off some staff, potentially hiring more relevant ones… Ideally, the borrower comes up with their own plan as a counterbid to the creditors’ plan involving pay cuts, asset sales, rationalizations, process improvements etc etc.

Fundamentally, it is futile to reorganize the debt of a business that doesn’t make sense. You cannot lever something into viability.

Europe needs to be more competitive. But if the Italians, Greeks and Spaniards were more competitive, then the Germans might be less so. It is not a point the debtor nations want to make to the creditor nations.

The approach taken by the French and German governments towards the debt crisis in peripheral Europe is to prescribe austerity as a means to solvency as a condition for financing at reasonable rates. So far the efforts have been lacking in detail and have thus not commanded the confidence of the bond markets.

Austerity is but one solution to restoring cash flow and balance sheet solvency. In the short run, austerity exacerbates the cash flow problem.

In the short term therefore, a non-economic lender of last resort is required. The ECB’s LTRO is designed specifically to this end but requires the (not necessarily guaranteed) participation of the commercial banks. (They do appear to be falling in line.)

Austerity absent the LTRO is not viable. Tax revenues would fall, so would profits, and eventually the insolvency of the peripheral economies would be crystallized.

Austerity requires time. It is hoped that the ECB has purchased sufficient time. Whether the market believes that it has or not will determine the path of bond prices going forward.

The debt and debt service reduction is but an intermediate goal to reduce borrowing costs in the future and thus improve debt reduction. With a common currency, localized domestic prices need to be more flexible, which would be evidenced by less stable prices, i.e. more volatile inflation. This is a consequence the ECB may struggle to reconcile with its price stability mandate.

Price stability could only result from a convergence, not necessarily an improvement, in respective national productivity, in each factor market. This seems to imply not merely a harmonization of fiscal policy but also of tax and welfare systems, a first extension from harmonization of macro policy to harmonization of micro policy, for example in labour and employment law and policy. The true scope of integration necessary to maintain the Euro, while implementing a viable plan of reorganization begins to dawn.

This is what Merkel and Sarkozy are on about. It is, however, a long term goal, and as we all know, in the long run we’re all dead anyway.

The trouble is that there are no short term solutions except pharmaceutical morphine, which the ECB has already shot in the arm. And that kind of medicine has ugly side effects such as inflation and risk of loss of confidence leading to all sorts of nasty things like hyperinflation and acutely high interest rates. Also it is a case of doubling down, requiring insolvent banks to purchase the very assets that caused their insolvency in the first place in the hope of holding up their value so as to stave off insolvency. Its all very precarious.

On Dec 21, 2011, the ECB printed 489 billion EUR. On Feb 28, 2012, one expects it to print even more. That’s a lot of morphine.

In the meantime, the surgeons scrubbing down don’t look too sure of themselves.

The ECB is printing money. It may not yet be directly purchasing sovereign bonds but it is acting as prime broker to the following hedge funds: commercial banks in Italy, Spain, France, Germany, etc etc.

On Dec 14, 2011 it became clear what the ECB’s intentions were. Faced with political constraints and bureaucracy regarding its mandate, a desperately practical ECB decided on a course of action to operate debt monetization on a significant scale circumventing the German government’s envisaged objections. For the full analysis of the ECB’s cunning plan, refer to The ECB is Ready For QE.

To reiterate, the 3 year repo achieves the following:

• Recapitalizes the banks.
• Puts a cap on sovereign yields.
• Supports the coming bond auctions.
• Disengages the cross border holdings of sovereign bonds within the Eurozone.
• Liquefies the money and capital markets.

Is this a good thing? Well, it will create a rally in European equities and bonds. It will cause low quality banks to outperform high quality banks. It will devalue the Euro, which is good for exports, and Europe is a massive link in global trade chains. But it debases the Euro big time. This means that gold and other real assets will rise in Euro terms.

Initially, given the average intelligence of the recreational FX investor, the Euro will rise, so watch out for the volatility.

There is a reason I call this Ten Seconds Into The Future. The chances of getting a forecast right on the economy are probably 50-60% if you’re good. The chances of translating that into a call on market direction are probably 45-55% if you’re good. So whenever I express an opinion, I’m setting myself up to be wrong. But everyone needs a hobby. So for 2012, here goes.

1. There will be no new crises or nasty surprises, but there are still lots of old ones.
2. The US economy will continue to consolidate its recovery. Unless China derails it.
3. The Chinese economy will continue to slowdown. There is a high chance that it accelerates into a hard landing.
4. Europe is clearly in a recession.
5. India is in a serious funk. Unless it can restart its export economy things can deteriorate even faster.
6. Latin America is likely to recover from its current slowdown on the back of a recovery in certain natural resource markets.
7. Australia is likely to get away with another resource driven recovery.

What are the implications for markets? This is much more difficult to formulate and much more difficult to get right.

1. US exporters are likely to suffer. US domestics are likely to prosper. This follows from (2) above. As the S&P500 is replete with companies with external exposure, the broad index is likely to suffer even if individual sectors and stocks prosper.
2. Asian exporters are likely to prosper. Asian domestics are likely to suffer. This follows from (2) and (3) above. As most large listed companies are exporters Asian stock indices are likely to rise, despite a weaker Asian economy.
3. European stocks are likely to suffer given their a) there large export exposure, b) the insolvency of their banking system, c) the inability of their political leaders to agree a long term or indeed short term solution for supporting their currency system and banking system. However, the ECB is now in QE(Stealth). QE(S) began 21 Dec 2011 with 489 billion EUR in 3 year repo funding. A second tranche is prepped for 28 Feb 2012.
4. China’s role in the world economy is more important than its relative size. The Chinese economy is growing fast but its not anywhere near the size of the US economy. That said, it plays a unique part in the global scheme of things. The current strength in the US economy originates from a revival in ‘exports’ and manufacturing. Exports are in parentheses since they are strictly not exports but the production by US companies operating abroad. The most important export markets in the current context are North and Latin America. The most important exports are capital goods. The final link in the chain is North and Latin American exports of resources to China. So (6) and (7) above rely on China growing its economy through a continuation of infrastructure investment.
5. We see evidence of a slowing Europe ((4) above) in German GDP numbers, so that even Europe’s main engine of growth is spluttering. The German economy exports directly to China. A weak German number is a red flag not on Germany (the signal is to late) but on China. Europe is also weak for other reasons, the main one being a now dysfunctional banking system and money market. No amount of printing by the ECB can solve a fundamental flaw in the Euro system. It can delay the consequences for a significant amount of time but in the end printing money and expanding credit to solve a debt problem is like putting out a fire with gasoline. A loss of confidence is always the root cause of hyperinflation. Until then, expect to see tighter spreads of European sovereigns than you would normally expect when the government is bankrupt. An interesting play on this is to invest via the European banks which will no doubt be parking their cash, apart from with the ECB, in their domestic sovereign’s quite worthless IOUs. And for this folly they will earn a spread, accumulate some capital and play a part in a less chaotic disintegration of the Euro if it happens down the road.
6. (E) above tells us that the Euro must weaken against gold and very likely against the USD even more than it has this past quarter.
7. (2) above argues for continued USD strength.
8. (1) above diminishes the probability of another round of US QE. Short rates are stuck at zero as the Fed tries to get some inflation going. The yield curve may start to steepen once Operation Twist is exhausted although it is likely that the banking system may be co-opted to keep it flat. The US still needs low long term rates to get the house owner back to positive equity and positive gearing. Refinancing at current levels of interest rates, if they were achievable, would unlock significant purchasing power for discretionary spending.
9. Some of the weakness in commodities is due to the dearth of commodity trade finance so there will be a coincident recovery to do with the capital positions of the European banks.
10. There is an interesting trade in European banks. Spanish and Italian banks are under a shorting ban because investors would like to short them. The natural trade for such investors is to buy puts. If one is of the contrarian view that the 3 year repo is a de facto bailout recapitalization of the European banks, one must prefer Spanish, Italian and French banks to German banks. The trade therefore involves going short the cash stock of German and creating synthetic long futures in Spanish, Italian and French banks through their options (selling the expensive put and buying the cheap call.)

If all this sounds rather benign or even bullish, then you misunderstand. All the above is relative to a nominal or fiat currency benchmark. In 2012, given that no one in their right mind would lend to either of Europe, the US or Japan, the Bank of England, Bank of Japan, ECB and the Fed will be printing warehouse loads of funny money for the sole purpose of lending it back to their governments’.

I eagerly await each day as it unfolds the continuing story of how too much debt was created in the past few decades and where we are going to hide it next. If you can identify the flow of capital and assets, this could go quite well for you. If you’re not even looking, then it is certainly no more than a game of chance.

Good luck. We all need a little bit.

So far most commentary about a possible break up of the Euro has focused on an instantaneous exit by a single country. Their expectation that it would inevitably be very damaging leading to extended bank holidays, highly probable defaults, bank runs, and capital flight are not incorrect. However, what they may have missed is that the Euro was not created in a day, and a country need not exit the Euro in a day.

The members of the European Monetary Union had a decade since the Maastrict Treaty to get their finances in order and to stabilize their currencies against one another and the ECU, a notional accounting currency, before the introduction of the Euro on 1 Jan 1999. Three years later Euro notes and coins were issued.

The logical step at this time is to prepare for a potential break up of the Euro.

Reduce external debt. This can be done if there are backstop buyers of European sovereign bonds. Apart from the ECB the only natural candidates are the European banks. It seems counterintuitive but European banks need not just to deleverage their balance sheets, they need to avoid currency mismatches in the event of a disintegration of the Euro. This means that European banks have to buy their own nation’s debt.

Banks need to have sufficient capital to instill some level of confidence. At the moment it is hard to see any buyer in sight save for some rather broke sovereigns. Alternatively there are retained earnings but where could this come from? Perhaps from a levered carry trade on the respective sovereign bonds.

A phased exit beginning with, for example, a pegged Drachma and Lira. The peg, to the Euro, could be established for a year after which there would be a managed float to keep the currencies within defined bands of the Euro. This would in effect be a reversal of the ECU mechanism. It would provide time for legal, logistical and commercial contracts and issues to be novated from the Euro to the local currencies. No amount of time can sort out political issues.

For the first time in its history the ECB is extending 3 year collateralized funding at 1% to European banks.

The take up for shorter term funding in this time of money market stress has been strong with some 197 banks borrowing 292 billion EUR over one week. The one month tender declined as the 3 year tender opens December 21. Forecasts for the take up of the 3 year tender range from 20 billion to 250 billion EUR. The take up is likely to be at the top end of forecasts or exceed it.

• Banks need stable funding. The 3 year tender provides them 3 year money with a 12 month break.
• Sovereigns need a backstop buyer for their bonds. European banks will be vessels of the ECB as it assumes the role of lender of last resort.
• Some sovereigns are still AAA or AA and carry a zero risk weight under Basel III. Banks are thus able to fund themselves at the ECB refi rate of 1% and lend at 1.5% to 3% to France, or at 5% to Italy or Spain.
• Banks are likely to purchase their own country’s debt instead of other countries’ debt. This is to mitigate the risk of a disintegration of the Euro. This will also reduce the intra Euro area cross border holdings of sovereign debt which will make a potential break up of the Euro less damaging. A cynic might suspect the ECB of envisaging and encouraging such an eventuality.
• The ECB will be able under this mechanism to operate debt monetization without explicitly buying sovereign debt. This will circumvent any legal or treaty issues which have confounded previous plans.
• Additionally this has the effect of recapitalizing the European banking system without equity dilution. Retained earnings count as capital.

And thus debt which was once transferred and transformed from private to government balance sheets may be transferred once again to private balance sheets with a little help from the ECB.