1914 is the New Black

Man in Black: All right. Where is the poison? The battle of wits has begun. It ends when you decide and we both drink, and find out who is right … and who is dead.

“The Princess Bride” (1987) 

Time is a game played beautifully by children.

Heraclitus of Ephesus (535 – 475 BC) 

How can you hide from what never goes away?

Heraclitus of Ephesus (535 – 475 BC)

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Whoever cannot seek the unforeseen sees nothing, for the known way is an impasse.

– Heraclitus of Ephesus (535 – 475 BC)

Let me just say that I am very negatively surprised by today’s decisions by the Greek government. That is a sad decision for Greece because it has closed the door on further talks, where the door was still open in my mind.

Jeroen Dijsselbloem, head of Eurogroup finance ministers

The judge smiled. Men are born for games. Nothing else. Every child knows that play is nobler than work. He knows too that the worth or merit of a game is not inherent in the game itself but rather in the value of that which is put at hazard. Games of chance require a wager to have meaning at all. Games of sport involve the skill and strength of the opponents and the humiliation of defeat and the pride of victory are in themselves sufficient stake because they inhere in the worth of the principals and define them. But trial of chance or trial of worth all games aspire to the condition of war for here that which is wagered swallows up game, player, all.

Cormac McCarthy, “Blood Meridian, or The Evening Redness in the West” (1985) 

I have always thought that in revolutions, especially democratic revolutions, madmen, not those so called by courtesy, but genuine madmen, have played a very considerable political part. One thing is certain, and that is that a condition of semi-madness is not unbecoming at such times, and often even leads to success.

Alexis de Tocqueville (1805 – 1859) 

Children and lunatics cut the Gordian knot which the poet spends his life patiently trying to untie.

Jean Cocteau (1889 – 1963) 

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If you don’t like how the table is set, turn over the table.

– Frank Underwood, “House of Cards” (2013)

Nothing like a good Friday-after-the-close blockbuster to set the stage for an interesting week.

At 1am Saturday morning Athens time, the Greek government called for a nationwide referendum to vote the Eurogroup’s reform + bailout proposal up or down. The vote will happen on Sunday, July 5th, but Greece will default on its IMF debt this Wednesday, and as a result the slow motion run on Greek banks is about to get a lot more fast motion unless capital controls are imposed. If you want to get into the weeds, Deutsche Bank put out a note, available here, that I think is both a well-written and comprehensive take on the facts at hand. As for the big picture, I’ve attached last week’s Epsilon Theory note (“Inherent Vice“), as this referendum is EXACTLY the sort of self-binding, “rip your brakes and steering wheel out of the car” strategy I wrote about as a highly effective way to play the game of Chicken.

Look, I have no idea whether or not Tsipras will be successful with this gambit. But I admire it. It’s a really smart move. It’s a wonderful display of what de Tocqueville praised as the “condition of semi-madness” that was so politically effective in 1848, and I suspect will be today. Plus, you can’t deny the sheer entertainment value of hearing Dijsselbloem splutter about how he was open to a revised, revised, Plan X from Greece all along, if only Tsipras would continue with this interminable charade. “The door was still open, in my mind.” Priceless.

So long as Tsipras can avoid market anarchy and TV coverage of violent ATM mobs this week, I think the NO vote is likely to win. The referendum is worded and timed in a way that allows very little room for Antonio Samaras and other Syriza opponents to turn the vote into a referendum on the Euro itself, which has proven to be a successful approach in the past. Particularly as the Eurogroup rather ham-handedly denied the request for a one-week extension in the default deadline, the referendum is being framed by Syriza as what Cormac McCarthy called a “condition of war”, an over-arching game where “that which is wagered swallows up game, player, all.” It may well be a close vote, but it’s hard to vote YES for a public humiliation of your own country under any circumstances, much less when that YES vote is being portrayed as giving aid and comfort to the enemy.

Here’s how I see the game playing out after the vote.

If Greece votes to accept the Eurogroup reform proposal after all, then the game of Chicken resolves itself within the stable Nash equilibrium of a shamed Greece and a triumphant Euro status quo. I would expect an enormous risk-on rally in equities and credit, particularly in Euro-area financials. Hard to say about rates … peripheral Euro debt (Italy, Spain) should rally, and German Bunds might, too, as the Narrative will be that Germany “won”. But reduction of systemic risk is a negative for any flight-to-safety trade, so this outcome is probably not good for Bunds in the long term, or US Treasuries over any term.

If Greece votes to reject the proposal, then either the game resolves itself within the stable Nash equilibrium of a shamed Euro status quo and a triumphant Greece (if the ECB and EU decide to cave to some form of the original Greek proposal), or we enter the death spiral phase of a game of Chicken, as all parties start to talk about how they “have no choice” but to crash their cars. That latter course is the far more likely path, I think, given how the various Euro Powers That Be are already positioning themselves. It’s all so very 1914-ish. Draghi’s cap on bank-supporting Emergency Liquidity Assistance (ELA) is the modern day equivalent of Czar Nicholas II’s troop mobilization. Good luck walking that back.

If we go down the death spiral path and some form of Greek exit from the Euro-system, I expect the dominant market Narrative to be that Greece committed economic suicide and that the rest of Europe will be just fine, thank you very much. That should prevent a big risk-off market move down, or at least keep it short-lived (although you should expect Bunds and USTs to do their risk-off thing here). Unless you’re a hedge fund trying to make a killing on those really cheap Greek bonds you bought two years ago, there’s no reason to panic even if we’re on the death spiral.

Over time, however, I expect that dominant Narrative to be flipped on its head. Greece will quickly do some sort of deal with Russia (hard currency for port access?), and then the IMF will strike a deal because that’s what the IMF does. More and more people will start to say, “Hey, this isn’t so bad”, which is actually the worst possible outcome for Draghi and Merkel. At that point, you’ll start to see the Narrative focus on the ECB balance sheet and credibility, and as Italian and Spanish rates start to creep up and as the spread to Bunds starts to widen, people will recall that ECB QE only has national banks buying their own debt … the Bundesbank ain’t propping up Italian sovereign debt. I suspect it will be a slow motion contagion, all taking place in the Narrative and expressed in Italian, Spanish, and French politics over the next 12 months or so. The Red King will start to wake.

One last point on how the market Narrative will shift if we go down the death spiral path, and that’s the dog that will stop barking. The incessant and often silly focus on Fed “lift-off” is about to go on summer hiatus, which can’t happen soon enough for me. 

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7 Quick Points on Europe

#1) Here are the most relevant recent notes for an Epsilon Theory perspective on the underlying political and market risks in Europe: “The Red King” (July 14, 2014) and “Now There’s Something You Don’t See Every Day, Chauncey” (Dec. 16, 2014).

#2) Markets reacted positively to last Thursday’s announcement because Draghi doubled the amount of QE that he leaked to the press on Wednesday. Financial media pegged QE at 600 billion euros on Wednesday and 1.2 trillion euros on Thursday. Once again, Draghi played the Narrative game like a maestro.

#3) This is NOT open-ended QE. Sorry, but the Narrative game doesn’t work like this. If you mention a target date (September 2016), then that becomes the Schelling focal point, no matter how much you try to walk that back by saying it’s open-ended.

#4) Risk-sharing, or the lack thereof, matters. Draghi won approval of a doubled QE target by minimizing the mutualization of QE risk among EU countries. 80% of the bond-buying will be done by national central banks, and Germany will only buy German government bonds, France will only buy French bonds, etc. That’s important for two reasons. First, if Italy or Spain goes off the rails, then the Bundesbank’s balance sheet isn’t immediately crippled. Second, this is why German bonds are rallying just as hard (harder, really) than periphery bonds. It’s also why US bonds are rallying so hard, because you can’t maintain a huge spread between the only risk-free rates left in the world.

#5) Market complacency on Greece is a mistake. Not because Greece itself is a huge systemic threat, but because the same political dynamics in Greece are coming soon to Italy. Greece is Bear Stearns. Italy is Lehman.

#6) In tail-risk trades as in comedy, timing is everything. Even if you think that it’s an attractively asymmetric risk/reward profile to bet on a Euro crisis (and I do), this is a heavily negative carry trade. If you don’t know what the phrase “negative carry trade” means, then please don’t make this bet. If you do know what it means, then you know that you either have to play a lot of hands to make the odds work out for you (and the nature of systemic crises makes that impossible) or you have to be spot-on with your timing.

#7) In a fundamentals-driven market you need to look at fund flows; in a Narrative-driven market you need to look at Narrative flows. With Draghi’s announcement last Thursday, there is no longer a marginal provider of market-supportive monetary policy Narrative. Or to put this in game theoretic terms, the 2nd derivative of the Narrative of Central Bank Omnipotence just flipped negative. We’ve shifted from an accelerating Narrative flow to a decelerating Narrative flow, and that inflection point in profoundly important in game-playing. The long grey slide of the Entropic Ending begins.

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Now There’s Something You Don’t See Every Day, Chauncey

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Narrator: Well, today we find our heroes flying along smoothly…
Rocket J. Squirrel: Flying along smoothly?
Bullwinkle J. Moose: You’re just looking at the picture sideways!
Rocket J. Squirrel: Actually it’s like this!
Narrator: Oh… OH GOOD HEAVENS! Today we find our heroes plunging straight down toward disaster at supersonic speed!
Bullwinkle J. Moose: That’s better.

The Rocky and Bullwinkle Show (1959 – 1964)

There are decades where nothing happens; and there are weeks where decades happen.

― Vladimir Lenin (1870 – 1924)

I have always thought that in revolutions, especially democratic revolutions, madmen, not those so called by courtesy, but genuine madmen, have played a very considerable political part. One thing is certain, and that is that a condition of semi-madness is not unbecoming at such times, and often even leads to success. 

― Alexis de Tocqueville (1805 – 1859)

A match as a pen
Blood on the floor as ink
The forgotten gauze cover as paper
But what should I write?
I might just manage my address
This ink is strange; it clots
I write you from a prison
in Greece.
― Alexanderos Panagoulis (1939 – 1976) 

The revolution is now just a sentiment.
― Pier Paolo Pasolini (1922 – 1975)

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Pedro: Vote for me, and all your wildest dreams will come true. 

― “Napoleon Dynamite” (2004)

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Tammy Metzler: [her campaign speech] Who cares about this stupid election? We all know it doesn’t matter who gets elected president of Carver. Do you really think it’s going to change anything around here? Make one single person smarter or happier or nicer? The only person it does matter to is the one who gets elected.
― “Election” (1999)

So inscrutable is the arrangement of causes and consequences in this world, that a two-penny duty on tea, unjustly imposed in a sequestered part of it, changes the condition of all its inhabitants.
― Thomas Jefferson, “Autobiography” (1821)

Like every other male homo sapiens I know, I watch a lot of sports. There’s only one team that I watch as a fan – the University of Alabama football team (my grandfather and uncle played there, and I was raised in the Church of Bear Bryant) – by which I mean that these are the only games I watch where I could not care less about the quality of the gameplay, but only care about winning in as lopsided a fashion as possible. For example, while the rest of the world thought the 2011 Championship game where Alabama beat LSU 21-0 was a miserably boring affair, a Bama fan like myself thought it was a performance of absolute beauty. Roll Tide.

Fans and gamblers care about outcomes. For everyone else watching a game, we’re there for something else. One of those things – and for me the centerpiece of any non-Bama, non-Hunt-participant sporting event – is the chance that we might see something we’ve never seen before. For example, a few weeks back I was watching the Sunday night Giants-Cowboys game on television even though I don’t really care about the New York Giants and the last time I rooted for the Dallas Cowboys was when I was 6 years old and wearing footie pajamas with a big blue star on them. A year from now I will no longer remember (and don’t care today) who won that game. But I will never forget the greatest catch I have ever seen – Odell Beckham, Jr. throwing himself backwards, reaching out behind his head, and cleanly catching the long pass with 3 fingers of one hand for a touchdown. That’s why I watch the games – for moments like this where something happens that I’ve never seen before and almost certainly never will again.

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I spend a lot of my time watching politics, too, which is just another type of game. And as with my sports-watching, I care deeply about the outcome in only a small fraction of the political events that I follow, mostly local elections, but occasionally broader elections that impact my personal notions of political identity or justice. For the vast majority of political events, though, I’m really just watching in hopes that something exciting will happen.

Last weekend’s election in Japan was the opposite of exciting. It was a foregone conclusion – roughly the equivalent of Alabama playing a Division III team – because Abe scheduled the vote in precisely the same way that powerhouse college football teams schedule creampuffs. Abe announced the election on November 18, giving the opposition parties less than a month to field candidates in the various prefectures (they don’t call them “snap elections” for nothing), which allowed many of his LDP candidates to run either unopposed or with token opposition. This sort of political ploy is impossible in the American electoral system and too risky in a system that requires the head of government to submit to a national vote or referendum, but it’s a smart play in Parliamentary systems where the Prime Minister is selected by virtue of his bureaucratic leadership of the political party with the most locally elected representatives. Abe has to win a seat in the Japanese Diet, just like John Boehner must be elected to Congress from his local Ohio district every two years, but Abe’s position as head of government stems from the same source as John Boehner’s House Speakership – the support of fellow party members and allied coalition party members – not some national vote on Abe himself. It allows a Prime Minister to reset the clock on his tenure as national leader by simply resetting the clock on the locally elected representatives who support him, and that’s a very powerful tool.

What it doesn’t mean, of course, is that Abe is a nationally elected leader or that his policies enjoy some sort of “mandate” from the Japanese electorate, even though this is naturally what Abe will claim. As Speaker of the House Tip O’Neill famously said, “all politics is local”, and that holds true for Japan (in fact, is probably more true) than for the US. The backbone of Abe’s majority in the Japanese Diet comes from single-member districts (as opposed to the larger multi-member and “block” districts), where it’s American-style plurality that elects one person to the House of Representatives (yes, same name for the lower House in both Japan and the US). So in a multi-party system like Japan with many competing parties and candidates, you can often win these single-member districts without a majority of votes even in the local district, much less on a national scale. And in fact Abe’s party – the LDP – won 78% of these single-member district seats with an aggregate vote of less than 50% of the single-member district voters. Combine this structurally-biased vote outcome with a record low voter turnout (about 52%), and it’s really hard to read this election as a full-throated popular vindication for Abenomics. But it was certainly the smart play for Abe to call for the election – because the outcome was never in doubt – and you can already read non-Japanese financial media like the Wall Street Journal talking about his “mandate”. It’s ridiculous and misleading, of course, but no more ridiculous or misleading than the Narrative creation that takes place constantly in The Hollow Market, most recently on oil prices.

The upcoming elections in Greece, however, are another matter entirely.

These snap elections are not a carefully planned tool of Narrative creation and status quo regime support as we just saw in Japan, but are … potentially … a keg of dynamite that could spark revolutionary change within the status quo European system. I use that word “revolution” cautiously, because it just doesn’t mean what it used to in the West, not even in Greece where as recently as 40 years ago revolution meant coups and armed insurrections and political prisoners. Revolution today is sentiment, a narrowly constrained concept where we talk about a return to a sovereign monetary policy as if it were the equivalent of storming the Bastille. Such is life in the Golden Age of the Central Banker. 

I know, I know … we’ve heard this song before, most recently in the late spring and early summer of 2012 when the threat of a Syriza-led coalition government and a Greek exit from the Euro threw global markets for a loop. New Democracy and its allies won enough seats to form a stable coalition, and just like that the Greek problem was “solved”. What’s different today? Not much. Time has passed. The real economy of Greece is just as broken as it was 3 years ago, but there’s been progress on the structural deficit (which makes an exit from the Euro more feasible) and there certainly doesn’t seem to be the same fear of the abyss (in Greece or the rest of the EU) as in 2012.

What’s really different about the Greek elections now and the Greek elections in 2012 is the lack of a Oh-My-God-Look-At-Greece media Narrative today, particularly in the US. You’ve got the occasional headline in the European press about what a Syriza-led government might mean for the Euro system, and certainly Greek equity markets (and in a reverberating sense Italian and Spanish markets) and Greek sovereign debt have taken it on the chin since the snap elections were announced. But US financial media has been almost totally AWOL on this story. Here it’s all oil, all the time, which means that any power transition in Greece will come as a big negative “surprise” to US investors and US markets. Certainly it will come as a negative surprise to all those US investors who have been loading up on European equities over the past two months in anticipation of Draghi launching a “dramatic” acceleration of ECB-flavored QE.

Now maybe we’ll see a repeat of June 2012 tomorrow and over the next few weeks. Maybe this will end up being a boring game where the two teams basically agree to a draw, to postpone the knock-down drag-out fight for another day. But there’s a decent chance that we’re going to see something in Greece that we’ve never seen before. There’s a bit of madness to the Greek electoral saga of the past 3 years that, as de Tocqueville pointed out, is the hallmark of democratic revolutions. And just as the somewhat mad IDEA of small-l liberalism spread like wildfire through Europe in 1848, deposing old-school aristocracies across the Continent, so, too, do I think that the somewhat mad idea of growth-oriented nationalism can depose the new-school aristocracies of the Troika. As Thomas Jefferson wrote in his autobiography, it’s amazing how a seemingly small event combined with a powerful idea – say a two-penny tax on tea in some far-off colony, combined with a determination by said colonists to demand representation – can change the entire world. The mandarins in Brussels and the apparatchiks in Frankfurt will speak of the events in Greece as “contagion”, a modern version of the same “scientific” language that royalists and their flunkies used in 1848 to condemn “the mob”. Good luck with that.

What’s the market impact of all this? Look, first of all this may be a false alarm and the Red King will simply return to his tranquil slumber. Second, even if Syriza takes control of the government they may ultimately prove to be just as status quo-oriented as New Democracy. That latter bit happens more often than you’d think. Second Republics can turn into Second Empires in the blink of an eye. But what I can tell you with confidence is that the Common Knowledge of the market today is that Greece is “fixed”, which means that any un-fixing will hit markets like a ton of bricks. It’s an asymmetric risk/reward profile – in a bad way – for global markets in general and European markets in particular from an Epsilon Theory perspective.

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