By Rob Parenteau
Just today, Michael Schussele pointed me to a number of articles on the European sovereign debt crisis. I think this is an important point about Italy running out of cash in Ambrose’s Evans-Pritchard’s article for the UK Telegraph. It must be one of the key reasons investors are fleeing Italian bonds (Spain has longer to go apparently, but same issue, just less debt maturing than Italy in the near term). Notice it is predicated on 1) both countries losing ability to sell debt to private investors, and 2) failure to increase EFSF funding in a timely manner, and so the funds available for secondary market purchases in government bond markets are eventually exhausted.
I believe, from my experience in the financial world, that institutional investors have learned how to create and game self-fulfilling prophecy runs in various asset markets. (George Soros understood this and demonstrated its efficacy with his effort to break the pound in 1992.) Indeed, this is one of the "secrets" to manufacturing higher absolute returns if you are a hedge fund portfolio manager – namely, creating and managing such bandwagon effects. One of the keys to this technique is to posit an investing thesis that cannot be immediately proven or disproven, whether you believe it to be possible or not., but which if more people believe it, it will, for a time, appear to come true.
Surely this is the case with the Italy is about to run out of cash before EFSF has a bigger war chest story. Yes, it is possible, but it may also be a low probability event, since, as we have seen all along, when the size of the risks are made apparent, the policy makers find ways to cut deals to keep the game going. In the meantime, it is a plausible simple story with a self-fulfilling aspect to it (the more people believe it, the higher yields go on Italian and Spanish government debt, and the more likely they find fewer private buyers of their debt). That attracts hedge funds.
Another way to think of it is that institutional investors are calling the policy maker’s bluff, and trying to judge how serious they are about using the new EFSF powers. The sharper ones will recognize that only the ECB has the unlimited firepower to take them on, which is one reason I suspect eventually we will see the policy makers agree that the ECB can buy EFSF issued liabilities.
Rob is sole proprietor at MacroStrategy Edge and research associate at the Levy Economics Institute.