Tuesday, May 11, 2010

The Era of Sovereign Default (so soon?)

Today, we will revisit some of our prior posts in light of the recent market volatility and a sudden emergence of the sovereign default as a central issue. On April 3, we published an article called "Greenspan and Bernanke (part 2): The Era of Sovereign Default" and on April 12, the one called "Implications for the Risk Management Process".

On April 3, we wrote the following:
"The volatility in the US dollar will be quite high, but the currency crisis is not imminent. The current low stock volatility (VIX is at 17) has to go up, but as long as Fed has the flexibility to inject massive liquidity any major drop in nominal equity or real estate prices will not persist."

The VIX is now at 30 after briefly hitting 42. The zero percent rate and not any fundamental indicator is what basically kept the market from continuing in a freefall.

On April 3, we wrote:
"Though the situation of the US government is dire, it has a major asset in the US dollar, which still remains the world's reserve currency. Other countries do not have such a golden goose. Therefore, as the current slump continues we are likely to see other sovereign debt crises a la Greece (this part of the article was written before the Portugal downgrade) in the shorter term. These sovereign crises will produce a temporary strength in the dollar. This will likely happen before we get to the point of high interest rates in the US and a partial default by inflation."

The dollar have strengthened significantly and US likely has some time due to its reserve currency status. However, the long run default (by inflation) of the US is nearly inevitable. The dollar may strengthen even more before its ultimate devaluation.

On April 12, we wrote:
"Currency volatility is going to be very high even in the absence of any extreme events. Avoiding unknown currency exposure, hedging, stress testing of currency rates are all very necessary."

This point is of paramount importance, since it is not clear in where the crisis will spread. The euro plunge have proven our point with a vengeance and those that did not bother to make currency stress testing and hedging a part of their process are paying the price.

On April 12, we wrote:
" what specifically can risk managers do to be better prepared for the decade of Black Swans? It is our opinion that the focus of risk is now in the sovereign area and multiple partial defaults by inflation are likely worldwide. The uncertainty surrounding these events is very high, but, as we argued time and again, risk management is not about estimating specific sequence of events or their timing, but rather about identifying instability potential and dangerous trends and being prepared with contingency plans."

These trends are very firmly entrenched and even moreso after the events of the last month and the announcement of the European stimulus.

On April 12 , we wrote:
"There are very few true hedges against these sovereign partial default by inflation scenarios (as there are few true hedges to anything). Oil, gold and commodities appear to be the only reasonable long term hedges at the cost of high intermediate volatility (disclaimer: authors do own gold and derivatives on it since November 2008). Risk managers would do well to watch the events and make appropriate decisions on hedging if the situation clearly worsens. This might be the reason such astute speculators as George Soros and John Paulson are loading up on gold (while talking it down in the case of Soros)."

Gold of course, have had a violent move upward. We are not claiming that we have predicted the timing of the event, everything we write is a probabilistic projection meant not as a direct investment advice, but as a guidance for risk managers. Gold will continue to be one of the true hedges to the increasing instability (no, the real recovery is not around the corner, unfortunately).

On April 12, we wrote:
"It is frequently said that the generals are prone to fighting the last war. Similarly, the world monetary authorities are still fighting the liquidity crisis, when there is really a worldwide solvency crisis looming. The coming decade can make 2000's seem calm by comparison."

The actions of Eurozone, preparing to inject $1 Trillion were almost inevitable, given the economic and political circumstances. However, it is quite impossible to solve the debt problem in the long run by printing or borrowing money (though the latter is possible, when a country's balance sheet is strong, not the case with Europe or US at the moment).
The bottom line is that our suggestions, some of which may have become obvious during the last few weeks (this is what happens when you are right), should really be implemented as part of a long term risk management process.
There are two things that we talked about that did not happen, yet should be on the radar of every risk manager for a long run:
1. Significant (400-500 bp) increas in the long term rates in the US and worldwide.
2. A number of global defaults by inflation culminating with the partial default by the US Government.
(not necessarily in that order)
Our advice given in the end of 2009 still stands: "Buckle up!".

Disclaimer: Authors do own gold and its derivatives.
Disclaimer 2: All this is merely our opinion, nobody has a crystal ball.

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