Without austerity the eurozone will come apart

“In order to bring debt ratios back on a downward path, euro area countries should not unravel their efforts to reduce government budget deficits.”

This is what Mario Draghi said on the ECB press conference last week. Although the ECB has always emphasized the importance of budgetary discipline, Draghi’s insistence indicates that the ECB might be getting a little nervous about the eurozone’s shifting views on austerity. This would be quite understandable - to accomplish its mission to keep the eurozone intact (and itself relevant), the ECB needs clear and agreed policies on fiscal deficits and structural reforms. Differences of opinion about fiscal policies are dangerous - not only because of potential political animosity, but also because they could weaken the commitment towards structural reform. Especially since the main threat to the ECB succeeding is a Germany becoming less supportive of the euro.

Perhaps the most acute concern for the ECB is that less fiscal restraint by eurozone members would undermine the feasibility of a full banking union, including a cross-border resolution mechanism. Since Germany currently holds the view that the creation of such a supra-national authority to shut down banks is premature and unwise, the last thing the ECB needs is dissent on budgetary discipline to validate the German apprehension. The ECB cannot do without a proper resolution capability to complement its new supervisory responsibilities. Without it, individual governments might refuse to close insolvent banks or have a lack of funds to do so. ECB board member Yves Mersch has pointed out that supervisors cannot give objective verdicts on the viability of banks if they can only be closed in a disorderly way.

But the current state of affairs does not look very promising for the ECB. For the time being, Germany continues to prefer an approach where individual eurozone members remain liable for their own costs. Only when local funds are insufficient and only after an official request is made by a national government (i.e. after the surrender of sovereignty), is Germany prepared to step in. It’s the old story: Germany wants to avoid putting its taxpayers on the hook for the resolution of banks whose problems are largely caused by deficient policies elsewhere. When Germany has to ride to the rescue, at least it wants to control the process. In addition, Germany may also want to avoid any outside mingling with its own thinly capitalized banks.

Professional ‘insiders’ don’t seem to give the creation of a binding framework for cross-border resolutions much of a chance either. This is what Simon Johnson recently wrote in Slate after attending the IMF spring meetings in Washington (my emphasis):

I had the opportunity to talk with senior officials and their advisers from various countries, including from Europe. I asked all of them the same question: When will we have a binding framework for cross-border resolution? The answers typically ranged from “not in our lifetimes” to “never.” Again, the reason is simple: Countries do not want to compromise their sovereignty or tie their hands in any way. Governments want the ability to decide how best to protect their countries’ perceived national interests when a crisis strikes.

Opening the door to more flexible austerity would also make the ECB’s OMT program politically (even) more difficult to deploy. Any ECB funding for a beneficiary country that would not be subjected to strict budgetary restrictions comes awfully close to the ‘verboten’ monetization of government debt. Given that the ECB is already seeing the bottom of its instrumental toolbox, a hollowing out of the OMT bluff weapon that has been so effective in calming the eurozone tensions must be a very unwelcome development.

Whether austerity is an appropriate policy or not, it is the political glue that has held the eurozone together until now. It was a simple common denominator that could be clearly specified and agreed upon, whilst providing political cover to governments for unpopular but necessary reforms. Most importantly, austerity complied with the fundamental political and economic beliefs of Germany. The moment the austerity doctrine is significantly watered down, the political cohesion within the eurozone will be diluted as well. This is particularly dangerous this close to the German elections with German politicians even more nationally oriented than usual - any showdown between Germany and countries demanding more fiscal leeway runs the risk of forcing an explosive existential outcome.

The Pandora’s Box of more fiscal flexibility has now been opened. Germany will tolerate an extra year here or there for countries to reach the three per cent deficit limit, but it is unlikely to go much beyond that. At the same time, the economic decay in the rest of the eurozone will continue, and so the pressure on Germany will mount, also by Brussels, to give more fiscal leeway to its fellow eurozone members. This will feed into the growing euro skeptic movement in Germany, that, unlike in most other countries, is supported by credible intellectual figureheads that carry a lot of weight (think for example of Hans-Werner Sinn, the President of the IFO Institute and, since recently, Oskar Lafontaine, finance minister at the time the euro was introduced).

Germany has principles and Germany has real options. The big market expectation is that a newly elected government in September will be more euro-minded than is suggested by the current rhetoric coming from German politicians. This remains very much to be seen. In the end, Germany faces a stark choice – either it accepts that it will be transferring money to the periphery for many years to come, or it leaves the eurozone and pays a price through a stronger currency and the recapitalization of its banks (including the Bundesbank). The debate on austerity is bringing the moment closer that Germany will have to make this fundamental decision. My expectation is still that Germany will opt for the ‘certainty’ of the past and will not accept the mutuality and unlimited liability consequences of a true monetary union.

If you take the view that the eurozone can only succeed with a full-fledged banking union and fiscal policies supported by Germany, it follows logically that the euro project in its current form is living on borrowed time. The years ahead will bring disorderly defaults of banks and possibly countries, with the bail-in danger for bank creditors depending very much on the nationality of the insolvent institution. Euro redenomination risk will rear its ugly head again; spreads between Bunds and peripheral debt seem way too tight.

Mayo42 signing off.

Wrong sing-along in the Netherlands

Sentiment in the Lowlands took somewhat of a rollercoaster ride over the past two weeks. It began with a mildly positive event, followed by a misguided attempt at boosting morale, and ended with a harsh reminder of economic reality.

A positive development

On April 11, the Dutch government announced that it had reached agreement (a so-called social accord) with representatives of both employers and trade unions how to co-operate on important labor market issues going forward – things like unemployment benefits, wages, pensions, and employment protection. The idea is that a pre-agreed overall compromise between the three social partners (government-business-labor) will prevent social unrest, disarm the political opposition, and boost confidence in the private sector. Here is how the FT reported the event.

To get the labor representatives on board, the government was forced to postpone until September a decision on the €4.3bn in extra austerity measures that are necessary to reach the Brussels’ three per cent maximum deficit in 2014. Always optimistic, the government expressed hope that the accord would give such a boost to private sector confidence in the coming months, that further cutbacks (read: tax increases) might no longer be necessary by September. Since this is highly speculative, it already undermined the accord’s positive effect.

The PR debacle

Possibly because of the unresolved budget uncertainties, prime minister Mark Rutte felt it necessary to assist people with their positive interpretation of this ‘historic’ agreement. In a televised interview, he called upon Dutch citizens to stop being gloomy and, given the improved visibility, help the economy by buying a new car or a house. Together we can beat the CPB forecasts! (CPB = Central Planning Bureau) was the message. As could be expected, Rutte’s simplistic peptalk completely backfired with an unreceptive audience that is finding it increasingly difficult to make ends meet. Political opponents and commentators had a field day at Rutte’s expense, deriding him for being completely out of touch with reality.

The hammer blow

How inappropriate Rutte’s rallying cry had been, became clear a few days later when the Central Bureau for Statistics published some truly horrific unemployment figures for the month of March. Seasonally adjusted unemployment in the Netherlands rose by 30,000 in March to a record 643,000, taking the unemployment rate to 8.1 per cent from 7.2 per cent three months earlier. Not only is unemployment increasing at a much faster pace than expected, particularly worrying is that the largest increase is among 25-44 year-olds.

But even before the awful employment numbers came out, Mark Rutte and his PR advisors should have known that he was playing with fire. Look at this graphic litany of Dutch economic misery (you can click on the individual headings for more info):

Bankruptcies of businesses and institutions (excluding one-man businesses)

Private sector investments in tangible fixed assets

 Consumer confidence, seasonally adjusted

Real disposable income and household consumption

Households with negative home equity, 1 January

Against this depressing background a nation needs credible leadership to keep the spirit up, not flippant opportunism. More empathic realism and less denial go a long way towards building confidence when times are this tough. Particularly when 'austerity' mostly means an increase in taxes and a squeeze in disposable income. The Dutch government's budget has increased from €239 billion in 2008 to €261 billion in the current year while taxes and social premiums went from 38 to 40 per cent of GDP. So who should be buying the new car then?

Mayo42 signing off.

A canary in the goldmine

Gold, barbarous relic or useful collateral? Amazing that people can be so polarized in their opinions about an asset class. It should be easy to be fairly agnostic about it: as long as central banks keep a large portion of their reserves in the form of gold and are adding to their positions, physical gold remains a credible store of value. How much validation does one need to accept that gold is a viable alternative? Don’t put all your eggs in one basket but it makes sense to have some gold, particularly in a financial environment that continues to be much more treacherous unpredictable than usual.

As could be expected with such a remarkably ‘controversial’ asset, the massive sell-off in the yellow metal was rejoiced by the anti-crowd. Gold’s collapse is eagerly interpreted as a sign that market conditions are normalizing and as confirmation that the expansion in central banks’ balance sheets does not entail significant inflationary or systemic risks. At long last the sour gold enthusiasts are getting their comeuppance while more constructive financial reasoning prevails. The bull runs in financial assets have steady legs and central bankers, including the academic theories that they base their policies on, stand vindicated by the market’s verdict.

For example, Joe Wiesenthal believes that ‘Everyone should be thrilled by the collapse in gold’:

So ultimately, the decline of gold and the rise of stocks is a big trend that everyone should cheer. The huge corpus of economic research, which has informed the US' efforts to stimulate the economy, is not a pile of garbage. You can do a lot without blowing things up, as the goldbugs claimed would happen. And more broadly, this represents a breaking of the fever, and perhaps a return to thinking that humans aren't such a horrible disappointment.

Felix Salmon also welcomes the ‘burst of the fear bubble’ and hopes that those manically depressed goldbugs will now start putting their money to more productive use:

Gold is the classic zero-coupon perpetual bond: an asset whose industrial value is a tiny fraction of its cash value, and which represents, as Joe Weisenthal says, a costly failure of markets to efficiently allocate capital to where it is best invested. Goldbugs are by their nature defeatist and pessimistic; get enough of them together at the same time and they become self-fulfilling. (That’s why they tend to be so evangelical about their beliefs.)

My hope is that the price of gold will continue to fall, that goldbugs will look increasingly silly, and that as a result Americans with savings will conclude that the best thing to do with those savings is to put them to work in a productive manner, rather than self-defeatingly trying to protect what they have.

But is this a case of being careful what you wish for?

If anything, if investors no longer fear inflation, they could logically expect the opposite and that is deflation – hardly encouraging for risk assets and implicitly meaning that central banks are incapable of generating more nominal growth. For growth to really take off and for consumer price inflation to become a serious risk, there will have to be wage inflation and, sadly enough, that remains highly unlikely given the dismal conditions in the developed countries’ labor markets, including the US. As long as labor has no bargaining power, there is little prospect for consumer price inflation and even cost-push inflation is a remote threat given the resultant chronic lack of demand. So no apparant need for gold as an inflation hedge, but maybe one should wish that it was needed.

That leaves the other big inflationary worry, asset inflation aka the wealth effect aka asset bubbles. When asset bubbles correct, gold will not protect against a rush for liquidity, at least not in the short run. This is logical since the main systemic purpose of gold is to serve as collateral that could be monetized in times of financial stress. When asset bubbles pop, distressed investors will rush to sell anything that can be sold in order not to run out of cash. The protection that gold offers under such circumstances, is continued access to liquidity.

So could it be then that the current sell-off in gold is a sign of stress in the system and, possibly, mounting worries that financial assets are getting seriously overvalued? This graph from Jeffrey Snider of Alhambra Investment Partners captures what happened in 2008 when the global credit bubble burst: three massive drawdowns in gold ranging from 16.5 per cent to 24.3 per cent.

As Jeffrey Snider points out in his excellent post, the first drop in gold preceded the big sell-off in equities that started a few months later:

Graph via Edgar-online

Looking at history for additional clues of what the downdraft in the gold price might mean brings you naturally to gold’s epic 1980 blow-off. In 1979 Paul Volcker was appointed as Chairman of the Fed and under his stewardship the Fed made a successful effort to end the inflationary spiral that had started in the 1970’s. By 1981, the Fed funds rate had reached 20 per cent while inflation peaked at 13.5 per cent (it subsequently fell back to 3.2 per cent by 1983). Today, we have ZIRP, tepid CPI and a Fed that specifically targets higher asset prices to improve conditions in a structurally challenged labor market. Now the question is, does 2013 rhyme better with 1981 or 2008?

Graph via Traderdannorcini

Mayo42 signing off.

Watch this if you want reasons not to buy a house in Holland

I haven't done video before so this is kind of an historic moment for me. A reader sent me this amateur documentary about a guy trying to figure out what to do about a house that he has been attempting to sell for the past 1.5 years - a bit like Michael Moore. Three interviews: with a broker, an expert, and an economist. Well made, pure, insightful. Unfortunately, I can only but totally agree with the analysis and sombre conclusions. The video is in Dutch so for those who don't speak the language a nice opportunity to whip out that dictionary. It also contains some interesting graphs.

Veel plezier!

Mayo42

Link:  http://www.youtube.com/watch?feature=player_embedded&v=M2c0Xn3sU70

Why a eurozone banking bail-in is inevitable

After years of dealing with existential doubts about the eurozone, politicians are now reaching the point where practical considerations are replacing the unattainable ideals of the past. Gone are the pipe dreams about political unification, fiscal pooling, and inter-country brotherhood. Instead, sobered up policymakers have resigned to making a badly designed monetary union work as is, accepting the fact that the project might stay hampered forever.

From a practical perspective, this means tackling the eurozone’s structural imbalances without being able to smooth the adjustments by transferring capital between member countries. It also means dealing with national interests that will continue to get in the way of optimal solutions. Most acutely, it means finding a workable solution for the eurozone’s undercapitalized banking system that needs to be fixed before any resumption of growth can be possible.

When it comes to cleaning up the banks’ balance sheets, policymakers might have fewer options than people think. Large amounts of festering bad assets have to be written down and thin equity buffers have to be increased. This will require a massive reset that just cannot be achieved in a non-disruptive way. Against the ongoing economic deterioration, building equity from retained earnings will take too long (if at all possible) and banks will not be able to raise sufficient additional equity in the primary market. Most governments in the eurozone reached the limits of their fiscal capacity already some time ago.

Under these circumstances there is really only one way to get the necessary recap done in an efficient and timely manner: through a massive bail-in of uninsured creditors. Here is the case:

The northern eurozone members are increasingly determined about what they don’t want to do, which is enter into any unlimited liability arrangement with the weaker eurozone members. This position comes from a growing awareness of what is practically feasible within the political and financial constraints at a national level. 

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 Rather than speeding up the process towards further unification, the increasing distress in the southern eurozone has accentuated the risks, making the northern eurozone members even more fearful of getting sucked into a transfer union.

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Calls for a full-fledged banking union (with a uniform resolution policy and deposit insurance), that are getting louder with each crisis incident, are only fuelling the political and financial apprehension in the northern eurozone countries.

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At the same time, the eurozone banking system needs an urgent recapitalization to stop a credit crunch that is aggravating the eurozone’s already poor growth dynamics, undermines the fiscal health of the sovereigns, and renders the ECB’s monetary stimulus ineffective.

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 The ESM, especially created for this purpose, is far from large enough to get the job done as a full-scale recap is likely to require several multiples of the ESM’s €500 billion (according to Herman Buiter for example, the price tag is €1-3 trillion). Since the eurozone countries will not (well, cannot) make any more money available, the only way to get it done is through the bail-in of insolvent banks’ unsecured and uninsured creditors and then use the ESM to cover any capital shortfalls.

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 The bank resolution policy that Jeroen Dijsselbloem ‘revealed’ is the only realistic alternative given the insurmountable political and financial constraints that exist. And without a significant banking sector clean-up, the eurozone will not be able to recover.

Market pundits were very quick to dismiss JD’s policy statements as dumb and irresponsible. Maybe so, but if you think in probabilities, that is not the most likely explanation for JD’s bluntness. I can assure you that a dumbo is extremely unlikely to become the minister of finance in a country like the Netherlands (particularly if the government consists of another political party that has to vet the appointment). Also, didn’t the pundits notice that there was no serious criticism from other policymakers, in fact, rather the opposite?

Another way of looking at JD’s declarations is that they might have been a semi-deliberate attempt to speed things up, to force weak banks into a restructuring. Time is running out for the eurozone as the economical and political situation is rapidly getting worse. Drastic action is required in short order, and an incisive recapitalization of the banking sector would be a good start. The dithering of Spain with its request for financial aid shows that some cheeky nudging might be needed to get things going. In fact, it would be in good calvinistic stead to bite the bullet and take the pain in order to have a better future rather than to deny and hope for a miracle.

As far as markets are concerned, this is definitely a risk-off signal for the bond markets that will motivate a flight to quality that is likely to continue for quite some time. Big cap international equities could also provide some liquid shelter from disruptive turbulence. Longer term, a banking sector restructuring would really improve the overall outlook for the eurozone which should eventually benefit local equities as well (and the currency, of course). In the interim, it could get quite choppy out there.

Mayo42 signing off.

Jeroen Dijsselbloem is the Voice of Holland

Or better, the Voice of the Core-Eurozone. While the Dutch president of the Eurogroup certainly didn’t win any popularity prizes with his candid policy reflections shortly after the Cyprus financial assistance package was finalized, his clarifications of what is to be expected next are totally in sync with the current political mood in the northern part of the eurozone. Although the timing of his delivery could have been better, JD makes a lot of sense and deserves to be supported. The Dutch parliament criticized JD in a debate yesterday about the way he had interacted with the media, but there was no disagreement with the contents of the communication.

Spot the difference

Here are a few quotes from JD’s predecessor, the illustrious Jean-Claude Juncker (via Wikiquote):

·         If it's a Yes, we will say 'on we go', and if it's a No we will say 'we continue'. (On the 2005 French referendum on the Lisbon Treaty).

·         Britain is different. Of course there will be transfers of sovereignty. But would I be intelligent to draw the attention of public opinion to this fact? (On the Lisbon Treaty, Le Soir).

·         Monetary policy is a serious issue. We should discuss this in secret, in the Eurogroup [...] I'm ready to be insulted as being insufficiently democratic, but I want to be serious [...] I am for secret, dark debates. (EUobserver, 21 April 2011)

If these texts are indicative of the qualities required of a president of the Eurogroup, JD is clearly the wrong man for the job as he sincerely believes in the importance of straight and honest communication (a bigger contrast with Juncker is hardly possible). This difference could be a positive for the sustainability of the eurozone - JD might regain some of the trust that was lost as a result of the calculating opportunism that is reflected in the above quotes. To give this a cultural twist: I would bet with confidence that JD is much more appreciated by the straightshooting Germans and Finns than by the pliable Belgians and Luxembourgers. And who are key for the survival of the monetary union? - right. Furthermore, JD’s main point, that the re-introduction of risk is necessary to get a more robust financial system, is hard to argue against and should have wide appeal.

Technocrats no longer rule the roost

He who pays the piper calls the tune, that is increasingly the political reality in the eurozone. If there is one lesson to be learned from the Cyprus saga, it is that the eurozone paymasters led by Germany are becoming less afraid of upsetting financial markets, and more driven by a desire to limit the deployment of their taxpayers’ money. The general idea is to lay the financial pain where it’s most appropriate - on shareholders, bondholders and uninsured depositors - and to reduce moral hazard in the system. Officials in Brussels and at central banks, who would take the lead in earlier bail-outs and who are more reluctant to inflict private sector losses for fear of destabilizing financial markets, are being overruled by the people who hold the purse strings. JD represents this revised pecking order.

This policy sharpening is not only coming from a desire to limit the damage for innocent taxpayers, but also by a swelling insistence on moral justice among national constituencies. Over the past years, there have been too many incidents where ‘compromised’ professional parties got away scot-free or even profited from bail-outs. People are getting seriously fed up with being served the bill and are angered by the abuses. Bank bail-outs are especially tricky because they always contain elements to stoke public indignation. In the case of the Cypriot banks, it was a business model that relied on tax evasion and ‘no questions asked’; in the case of the Dutch bank SNS it was hubris, fraud, and irresponsible risk-taking; in the case of Bankia it was cronyism and corruption. With ‘justice’ creeping in as an essential condition to gain sufficient political support in the benefactor countries, anybody funding a bank who is not insured or collateralized is seriously at risk of getting an ugly haircut when things go wrong.

What’s new and what not

A clear indication that the times are a changin’ is the fact that JD didn’t cave in to the market uproar and retract his statements, he just clarified and toned them down a bit. In any case, JD didn’t say anything particularly new, at least not to anybody who has been paying attention to what had happened in recent comparable situations (such as Bank of Ireland, Bankia, SNS Reaal). So JD’s statements to FT/Reuters may have been somewhat clumsy, there was no real surprise there and markets calmed down already the next day.

The big underlying friction in the eurozone continues to be about who is going to pay for the massive legacy liabilities. The posturing of the northern eurozone in the Cyprus rescue is in line with their earlier refusal to pay for other people’s problems pre-dating the creation of the ESM. And it is also indicative of how the north sees the application of ESM funds. Any acceptable resolution of an insolvent bank will put maximum pain on the uninsured creditors of a bank first before the ESM will be allowed to inject whatever residual capital is required. This means that the bank’s own sovereign remains the first line of defense in case of an insolvency and that the moment you have to go cross-border and appeal to the ESM, you are in very deep do-do indeed. Since this is the only flavor of capital support that will politically fly in the north, it is the practical reality whether markets like it or not.

What’s also not really new is the realization that eurozone banks are still seriously undercapitalized. Up until recently, anybody who held paper that was not included in a small sliver of Tier 1 or 2 capital felt reasonably confident that systemic fears with policymakers would ensure that he would not be impaired in case of an insolvency. Those cushy times are definitely gone and investors now have to deal with the fact that the Emperor is only wearing some skimpy underwear while living in a palace where the roof might be leaking.

Lastly, the term Whatever it takes, so effectively utilized by Mario Draghi when he announced the OMT program, might be getting a more negative connotation in the times ahead as the risk of capital controls, forced borrowing and wealth taxes will become more real. The eurozone will try to survive, whatever it takes.

Mayo42 signing off.

The size of Cyprus is the BIG issue

Doom and gloom everywhere regarding the implications of the Cyprus bail-out. Making small deposit holders bleed while they were supposed to be insured by their government is clearly setting a dangerous precedent. There are just no good options for Cyprus: whatever rescue package is finally approved, it risks seriously destabilizing the eurozone.

The biggest problem with bailing out tiny Cyprus was always its insignificance at 0.2 per cent of eurozone GDP. With that size, it could never be credibly sold to the European public that a bail-out of Cyprus was a necessity. Consequently, supporting Cyprus felt somewhat optional (more than Greece in any case), almost like a charitable undertaking. A ‘charity’ that would have to be extended with strict conditionality given the moral objections against saving a dodgy tax haven with a ludicrously oversized banking sector specializing in money laundering for wealthy Russians (at least, that’s the general perception).

So any deal to help Cyprus had to include a meaningful contribution by its foreign depositors to be politically palatable, particularly in Germany. Anything less would have caused an existential crisis in the eurozone for sure, providing life ammunition to any ‘insurgent populist clown’ with a desire to obstruct the euro project. At least this non-negotiable Russian haircut had been clearly communicated beforehand, so the announcement of a special tax on deposits in excess of €100k came as a surprise to no one. The blindsider in the deal was the bail-in of small depositors who were supposedly protected by a guarantee from the Cypriot government (in accordance with EU guidelines).

Now the big question on everyone’s mind is why this had to be done since the deposits above €100k were large enough to easily cover the €5.8 billion required (it would take a haircut of roughly 15 per cent). And leaving small deposits intact would not only have been morally preferable, but also technically defensible given the government guarantee already in place. So why take the risk of upsetting the world?

Joseph Cotterill at FTA gives the most likely reason for spreading the pain to small depositors:

More to the point, someone clearly balked at increasing the rate above 10 per cent for big-ticket depositors — because why else distribute pain to small holders to make up for it. Someone has an eye on Cyprus somehow maintaining a future as an offshore banking centre.

According to this article (FT-Peter Spiegel) that describes the course of events leading up to the final proposition, that 'someone' was the Cypriot government:

Several officials suggested putting all of the burden on deposits over €100,000. Berlin was agnostic about where the axe fell. But Cypriot officials, with the backing of the commission, felt anything over 10 per cent would appear so onerous that it would make the situation even worse.

“The Cypriot president did not want to agree to a levy higher than 10 per cent,” said one top negotiator. “People were joking that he has only rich friends.”

Another practical reason for the government’s reluctance to cut the Russians too much might be the extent to which large deposits at Cypriot banks could be closely tied to specific assets. A classic way to launder money is via a so-called back-to-back arrangement. In such a structure, the bank’s client borrows ‘clean’ money that he has first deposited as ‘black’ money (in other words, the client funds his own loan). In the good old days, banks in Switzerland and Luxembourg made tons of money providing this service. It is an almost risk free business for a bank (if you don’t care about your international reputation) as the client’s deposit fully collateralizes his loan. However, when you haircut the funding leg of such a deal, you are likely to impair the asset leg as well (i.e. the outstanding loan).

Arguably, many mistakes have been made by eurozone policymakers on the road to this hairy predicament, but insisting on bailing in small deposit holders does not seem to be one of them. The big recent mistake would be that they gave the Cypriot government the leeway to determine who would take what pain. Well, at least that implies that the Eurogroup policymakers didn’t necessarily act stupidly, they were just sloppy in their execution management..

How do we go forward from here? Under the circumstances, I just can’t see how an implosion of the Cypriot banking system can be avoided. Deposits will be withdrawn and assets will crumble. This is a case of Too Big To Save writ large – too big relative to the Cypriot economy, and too big for the political credit of the Eurogroup. Seatbelts anyone?

Mayo42 signing off.

Please stop giving ‘new’ markets the ‘old’ treatment

One drawback of asset values that are largely determined by government policies is that they become pretty useless to gauge genuine investor demand. This practical consequence of a tightly managed financial reality is so blindingly obvious, that I find it amazing that in the ongoing financial discussion most ‘professionals’ continue to treat current market signals as if it’s business as usual. A lot of this is probably caused by habitual bias (that I am also struggling with), but some of it might be a bit more manipulative and malignant. In any case, it’s dangerous.

The point is easy to illustrate.

Since 2009, the Fed has monetized some 50 per cent of US government debt. Unavoidably this has suppressed US long term interest rates, particularly considering that prior to 2009 such purchases by the Fed were almost negligible.

Graph via Zerohedge

Here is a detailed representation of Fed’s current ownership of individual Treasury issues across the full maturity spectrum. The graph clearly shows that the Fed is hogging the longer dated maturities, even to the extent that several issues have reached the maximum statutory ownership limit of 70%.

Graph via Zerohedge

Maintaining under these circumstances that the all-important US risk-free rates - the price of US government debt that drives all US asset valuations from equities to RMBS - provide a reliable indication of private sector investment appetite, is quite silly. One can just no longer know.

That is not what Gavyn Davies believes. This is what he wrote on FTA a few days ago when opining whether equities are fairly valued:

Recent work by economists at Goldman Sachs concludes that QE 1, 2 and 3 have depressed bond yields by about 100-125 basis points. This therefore leaves a large part of the decline in yields to be explained by other more fundamental factors, including low inflation expectations, the global savings surplus and investors’ preference for safe assets. Evidence suggests that a little less than half of the decline in bond yields since 2007 has been due to QE, with the rest due to these other factors.

These people at Goldman must be very clever indeed. I haven’t seen their analysis, but being this precise about the effect of quantitative easing is truly remarkable. I mean, this is a market that is defined by one very special buyer (the Fed) who has superior information, special market access and, most importantly, unlimited resources (a money printing press). This privileged buyer has a keen and express interest in keeping rates subdued, not in the least because it already owns half the supply of the past four years. All this, while the other market participants are fully aware of the buyer’s policy objectives and superior systemic leverage. Within this overwhelming ‘technical’ reality, it was possible to pin the effect of QE at a neat 125 basis points or thereabouts? Awesome!! I am sure these Goldman analysts could also rationalize the 10 year Treasury at 5.82 per cent. Or whatever.

Regarding equity market euphoria, here’s a graph that shows the declining volumes on the NYSE in recent years while the market worked its way towards new all-time-highs. Hardly the convincing picture of a healthy undisturbed open market that has taken an advance on more prosperous times ahead.

Graph via theautomaticearth.com

Last week, Paul Krugman had a vicious go in his NYT column at ‘conservative economic pundits’ who had claimed to understand markets and who had warned that stocks would plunge and interest rates would soar if the US government would not bring its spending under control. At face value this seems reasonably fair criticism, until you realize that the Fed is not even mentioned once in the professor’s self-congratulatory tirade (here is the thing solemnly titled The Market Speaks).

Some quotes from Krugman’s rant that are symptomatic of the false signaling that we should be wary of:

What, then, are the markets actually telling us?

I wish I could say that it’s all good news, but it isn’t. Those low interest rates are the sign of an economy that is nowhere near to a full recovery from the financial crisis of 2008, while the high level of stock prices shouldn’t be cause for celebration; it is, in large part, a reflection of the growing disconnect between productivity and wages.

And:

So the message from the markets is by no means a happy one. What the markets are clearly saying, however, is that the fears and prejudices that have dominated Washington discussion for years are entirely misguided.

The bearded wordsmith then finishes his discourse with an acidy putdown of clueless prejudiced peddlers who should shut up:

And they’re also telling us that the people who have been feeding those fears and peddling those prejudices don’t have a clue about how the economy actually works.

Ahum - did Krugman ever consider the possibility that these petty peddlers might have been right if the Fed hadn’t done so much monetization? Whether his ‘incomplete’ interpretation of current market circumstances is deliberate or not does not really matter. Either way, you would expect a higher standard from a Nobel laureate – intellectually, ethically or otherwise. What the man is aggressively claiming here is so painfully populist, that I am almost embarrassed on his behalf.

Talking about bearded chaps (yes, Gavyn Davies sports one as well), Ben Bernanke’s recent testimony was probably an even bigger insult to the average investor’s intelligence. Without any discernible irony, Bernanke gave Congress the circular reasoning that the Fed’s policies are justified /benign/working because market levels are where they are. For cryin’ out loud – Ben, you ARE the market!

Mayo42 signing off.

Equity as the new new safe asset

Izabella Kaminski at FTA believes that Gregg Gibbs, senior foreign-exchange strategist at RBS, made a very important statement on CNBC’s Asia Squawk Box on Wednesday. “We have been looking at the Dow as the new safe haven,” Gibbs said. 

According to Izabella Kaminski, this simple statement cuts right through the Gordian tangles spun by financial pundits, academics, fund managers and analysts who tend to over-complicate matters in their analyses of today’s markets (here is her post titled The Age of Infinite Equity?). Gibbs' statement holds the key to the essence of the ‘new normal’ in financial markets and explains the relentless rise in equity prices. The main message of this ‘breathtaking’ statement is the realisation that:

The government will continue to support the market no matter what.

Wow! In other words: accept that the government will not stop stimulating and that this stimulus will have to go somewhere, regardless of the macro. With debt hitting its valuation boundaries and with the eroding ‘safety’ aspects, equity has increasingly become a viable alternative that has an unlimited capacity to absorb fresh capital looking for a home (read: to inflate to infinity).

Quoting from Izabella Kaminski’s post (emphasis mine)

Why is it that those who once got things so right are now failing to predict things accurately? I would argue it’s because, just like me, they have been slow to recognise the awesome power of government intervention. Once we appreciate this, and the fact that markets have de facto been nationalised, it’s easy to understand why we’re sitting on such a major inflection point when it comes to equity valuation.

Government support for debt markets has gone about as far as it can. From here on the scramble for a finite number of “safe” debt assets becomes self defeating on account of negative rates and the zero bound. What you acquire in safety you must pay for in negative yield. There are consequently no real safe debt assets anymore. Equity on the other hand has no such cap. It has, as many people now recognise, infinite potential.

Well, I don’t think anybody would disagree with most of Izabella Kaminski’s post – either with the observation that asset prices are where they are largely as a result of government interference, or that the ability (and willingness!) of governments to determine outcomes in financial markets was greatly underestimated by most pundits. Where some would disagree, including yours truly, is with her implied suggestion that this ‘new normal’ of nationalised markets will be with us for an indefinite time.

The big question remains whether government engineered asset valuations can be a solution to our economic and societal troubles or whether they are part of the problem - at least on balance. If the latter is the case, these artificial valuations will prove unsustainable in the longer run and the notion of equities as a safe haven will be a temporary phenomenon only (deliberate understatement).

Izabella Kaminski boldly asserts that ‘more traditionally minded’ investors like Stanley Druckenmiller fail to acknowledge that things are fundamentally different this time. I am not so sure about that. The old veterans may in fact be even more aware of the governments’ tinkering with financial markets than anyone else - it is where a large part of their unease is coming from. It is very brave to call them wrong while the jury is still very much out for judgment on this one (yes yes, I know, if you wait for confirmation you will never make any money).

Undermining the price discovery mechanism of markets and rendering fundamentals irrelevant degrades investing (or capital allocation if you like) to gambling in a rigged casino where the management can change the odds at will. In such an arbitrary environment nothing is ‘safe’. And nothing good can flourish. If that’s the ‘new normal’, I am afraid we are on the wrong track.

May42 signing off.

Great minds think alike...

 ...but maybe not always at the same time. Below is the full text of a comment in the FT Lex column of March 1. 

       US sequestration: drama, comedy, horror         
          A collective case of shock fatigue suggests we have reached midseries malaise

Think of recent US fiscal policy as a film franchise – part drama, part comedy, part horror. The opening instalment was the summer 2011 blockbuster, Debt Ceiling. The downgrade of US debt after the default brinkmanship made our jaws drop, but was followed by a clever plot twist: Treasuries rallied to all-time lows. And the brilliant producers, President Barack Obama and Speaker John Boehner, planted the seeds for a string of sequels. The winter showdown, Fiscal Cliff, ended with a feel-good (if temporary) holiday compromise.

But with Friday’s release of Sequestration, featuring $85bn in automatic spending cuts slated for 2013 (the first of $1.2tn over a decade), we have reached mid-series malaise. The collective yawn from all involved indicate that this edition is one big plot hole. Mr Obama has hit the talk show circuit to vainly stoke up fervour among ordinary Americans. However his golf vacation, along with meaningless negotiations with Republicans, betray that Washington is resting up for its next project.

What movie is the market watching instead? The reliable if dry Earnings Season is playing alongside the remake of Merger Mania (not as thrilling as the 2007 version) and with this double feature, the Dow is closing in on its all-time high of 14,164.

That said, the defence names are indeed hitting the theatres for Sequestration. Northrop Grumman, General Dynamics, and Lockheed Martin are down as much as 5 per cent this year. The smaller defence companies that are more geared towards services could be harder hit. The government and military consultant, Booz Allen Hamilton is down nearly a tenth.

The next contribution, Government Shutdown (an homage to the 1996 classic starring Bill Clinton and Newt Gingrich) is only weeks away as Uncle Sam needs to fund its future operations. And Debt Ceiling III: Dirty Barry is slated for this summer, though these next two could mercifully be wrapped into one grand (bargain) finale.

Compare this to my eerily similar post of January 16 with the title 'Now we have to deal with that US debt ceiling – yawn' (click here). Hmm.... I guess this must be just a coincidence considering that the Financial Times is one of the most aggressively restrictive publications when it comes to reproduction of its contents. Typical?

May042 signing off 

Will we get crushed under the weight of financial assets?

It has to be said, the first stage of the Fed’s plan to revive the US economy through the inflation of assets (the wealth effect) has been a resounding success. Any asset that could be affected by monetary stimulus is now getting pretty much fully valued (and perhaps beyond) despite an economic growth outlook that remains hardly convincing - bond yields are still near their historical lows (and negative when CPI is taken into account), US equity indices are near all-time highs, and the US housing market is rebounding. According to BofAML, for example, current investor sentiment towards risk assets is at a more bullish level than in 99% of their readings since 2002.

Now, if the freshly created investor wealth subsequently translates into the additional spending that the US economy (and the world) so badly needs, the Fed’s plan will have worked. Or will it? Because if a significant part of these engineered capital gains turn out to be as illusory as the phantom gains that were so optimistically spent by investors during the earlier dotcom and US housing booms, we are likely to suffer an even bigger hangover in the not too distant future than the one we are trying to deal with now.

The dangers of illusory wealth created by monetary policy is the topic of a timely op-ed titled ‘The Fed’s Asset-Inflation Machine’ by the author and erstwhile WSJ editor George Melloan. Despite the final outcome of his tenure as Chairman of the Fed, Melloan expresses some appreciation for Alan Greenspan who at least pointed out the dangers of fictitious profits from monetary stimulus when he talked in his famous speech in 1996 to the AEI about his concerns regarding ‘irrational exuberance’ fueling asset inflation. Unfortunately, Alan Greenspan in the end failed to heed his own warnings and allowed the massive credit binge that blew up so dramatically in 2008.

George Melloan is far from convinced that Ben Bernanke & Co are sufficiently aware of the dangers of the monetary policies they are so fervently pursuing. Reflecting on the US policy action since 2008, he hails back to the German economist Kurt Richebächer who used the dreaded H-word to describe the excessive expansion in credit (emphasis mine):

The Fed policy of quantitative easing is designed to rebuild the asset inflation edifice that collapsed in 2008. German banker and economist Kurt Richebächer provided some of the earliest warnings of the dangers. In his April 2005 newsletter, he wrote that "there is always one and the same cause of [asset inflation], and that is credit creation in excess of current saving leading to demand growth in excess of output."  Richebächer added that "a credit expansion in the United States of close to $10 trillion—in relation to nominal GDP growth of barely $2 trillion over the last four years since 2000—definitely represents more than the usual dose of inflationary credit excess. This is really hyperinflation in terms of credit creation."

In a recent paper by the consulting firm Bain & Company titled ‘A World Awash in Capital’, an attempt is made to put some numbers to the extent of asset inflation that has occurred. The Bain report starts with the observation that the rate of growth of the world’s output of goods and services has been in an extended slowdown over recent decades, while in the same period the volume of global financial assets expanded at a rapid pace. By 2010, global capital had swollen to some $600 trillion, tripling since the early 1990s, with total financial assets nearly 10 times the value of global output.

According to Bain, this bloated financial economy started with the end of Bretton Woods in 1971 (so gold bugs may have a point):

The expansion of the financial sector has accounted for an increasing share of world economic growth for years. The shift began with the end of the Bretton Woods system in the early 1970s and has accelerated since the 1980s with the advent of financial engineering, computing power and regulatory changes that reinforced it. The steady, decades-long buildup of financial capital has masked the fact that real economic growth was slowing.

Bain projects a lot more of the same going forward (addition mine):

Looking beyond today’s market conditions, however, our analysis found that capital superabundance will continue to exert a dominant influence on investment patterns for years to come. Bain projects that the volume of total financial assets will rise by some 50%, from $600 trillion in 2010 to $900 trillion by 2020 (all figures are in US dollars at the 2010 price level and market foreign exchange rates), even as the world economy increases by [only] $27 trillion over the same period (see Figure 1.1).

Bain then rather predictably warns the reader that asset bubbles are a huge threat to our systemic stability (emphasis mine)

Facing capital superabundance, investors are straining to find a sufficient supply of attractive productive assets to absorb it all. The sheer volume of liquidity being pumped into the markets by major central banks has sparked inflation fears. Stockpiled with financial assets, yield-hungry investors are venturing well beyond sustainable income-producing investments in pursuit of returns that for many could prove illusory. Given the ample spare capacity for production across the world, however, we expect that inflation will not show up in core prices in most markets but rather in asset bubbles, which have moved from being relatively isolated events to system-shaking crises claiming trillions of dollars in losses. Over the coming years, the ease, speed and magnitude of global capital moving around world markets will make the knock-on effects of the bubbles it creates deeper and more disruptive.

The question is whether the current ebullient mood in financial markets (and possibly the tentative switch from bonds to equities) is just a sign of surrender by investors as they accept a Fed induced world of relentlessly continuing asset inflation (a collective ‘don’t fight the Fed’), or is the bullish stance an encouraging precursor of real economic recovery. In other words, is this bull market a resignation to asset inflation or an indication that things will get better in the real economy?

History will tell whether the Fed’s success to date will be a Pyrrhic victory in the longer run. I am holding my breath.

Mayo42 signing off.

A Dutch shot across the bow of European bank debt

Last week the Financial Times (like any other financial publication worth its salt) included an article on the implications of the nationalization of the Netherlands’ fourth largest bank, SNS Reaal. The subtitle of the FT article, Bondholders be warned: bank rescues could cost you dear, succinctly captured the main conclusion to be derived from this financial drama. Not only were the troubled bank’s subordinated bondholders fully disowned by the Dutch government, its senior bondholders also came awfully close to being clipped. In the end, the fresh Dutch finance minister Jeroen Dijsselbloem decided to leave the senior bondholders whole (at the insistence of the Dutch central bank), but the general drift is clear: banking default risks, also for senior bondholders, are to be taken more seriously from now on.

Naturally, the price action in the (up until now remarkably complacent) markets for European bank debt has started to reflect the changing risk perceptions. According to the IFR, the iTraxx Subordinated Financials Index widened by 47bp over the past two weeks to 269bp, while the spread to the Senior Financials Index has moved out sharply to 115bp from tights of 78bp in early January (the basis between the indices hit a peak of 209bp in May 2012).

Although the international media reporting on the SNS drama has tended to be factually correct, it has also been incomplete as it typically did not touch upon the ‘intangible’ local political and emotional aspects of the situation that could be just as important to appreciate its significance. Readers are left unaware that the SNS story was the main media topic for the past two weeks in the NL, crowding out almost everything else, and there is no mention of the immense anger storm that was unleashed, an anger totally shared between public and politicians of all parties, whether part of the government or in the opposition.

I can’t remember ever seeing in the NL such a uniformly shared feeling of shock, indignation, frustration and disgust as in the case of SNS. There was absolutely zero empathy for anybody professionally entangled in the situation, with every politician (undoubtedly extra inspired by the public anger) prepared to go as far as possible to lay the financial consequences of the debacle on those who had benefited from SNS’s risky behavior and minimize the burden for hapless taxpayers. Civility disappeared, and particularly the bank’s management was relentlessly vilified in every forum possible. Not a lynching party yet, but coming pretty close.

What particularly fueled the indignation was the fact that apparently not enough had been learned from the hasty bail-outs of Dutch banks in 2008. A shiny new intervention law that had been approved last year to deal with situations such as these turned out to be hopelessly inadequate; the bank’s management could not really be held accountable for the disaster let alone be forced to repay their undeserved bonuses; and the Dutch central bank has again a lot of egg on its supervisory face (and is even accused by some of helping ABN Amro to stuff SNS in 2006 with the toxic Property Finance unit that caused its eventual demise).

What the SNS inspired anger implies is that the general public is getting less susceptible to systemic danger arguments to justify financial bail outs. Taxpayers want to see financial failure treated just like any other bankruptcy (whereby the state can step in to protect the bank’s retail clients). In addition, taxpayers are getting less tolerant with regard to any shortcomings in the system itself (that is supposed to be largely fixed and more resilient by now). Consequently, growing public resentment and pushback will make it increasingly difficult for politicians and regulators to present solutions that let professional parties in a bank failure off the hook. And the ‘acute crisis' argument to justify morally undesirable outcomes is no longer an acceptable line.

It would not surprise me if the Dutch SNS experience was quite representative of the public mood all over Europe. I would therefore think thrice before I invested in any European subordinated bank debt and I would also be very selective about investing in any senior unsecured bank debt. The public is clearly fed up with getting stuck with the bill for irresponsible banking and the mood is turning vigilant.This frustrated desire for moral justice will be increasingly difficult for politicians and policymakers to circumvent. Implied sovereign guarantees on bank debt have just been revalued down to reflect that.

Oh, and I would not like to be the one to break the news of a Cyprus bail out to the Dutch people.

Mayo42 signing off.

America Inc.

We all know that we are living in a world that is far from perfect. Which is sort of OK since it is nice to have some room for improvement. But where our imperfect world can become detrimental to our frame of mind is when there are signals that things may actually be getting worse.

A few weeks ago, I watched Brad Pitt’s gangster movie Killing Them Softly, a chilling tale and ‘barely disguised metaphor for the wider economics, politics and values of the US’. A key quote that captures the fundamental message of the film is the line America is not a country, it's a business.

As much as I would like to believe that Brad Pitt’s movie is overly cynical, recent events seem to indicate that his disconcerting take on what’s going on in the US may not be entirely divorced from reality:

·         Large US financial institutions are deemed too important to prosecute. This is what Simon Johnson, the former chief economist of the IMF, had to say about that via Bloomberg a few days ago. He is not only disturbed by the fact that certain institutions have apparently been put above the law, but also because it is totally unclear who and/or what is behind that determination by the Department of Justice. He ends his op-ed on a very somber note:

America’s past was dramatic and not always glorious. Our present is sordid. Financial shenanigans damaged the economy, and now a handful of powerful executives and their companies have received get-out-of-jail-free cards. It’s official. The Justice Department said it loud and clear: No megabank will ever face meaningful prosecution. Very big banks should be broken up immediately. That won’t happen.

·        Then there is this strong whiff of revenge surrounding the suing of Standard & Poor by the Department of Justice for fraud related to ratings issued on mortgage-backed securities. This is what the WSJ implied in its editorial on the topic:

There are other disturbing questions related to the timing and the target of this federal civil prosecution. S&P’s attorney Floyd Abrams tells us that “things seemed to rev up in terms of the intensity” of the federal investigation after S&P’s historic downgrade of United States credit following Washington’s debt-limit fight in 2011.  Meanwhile, a McClatchy Newspapers report says that it was around that time that Moody’s, which did not downgrade the government, was dropped from the federal investigation. Ask any investor and he’ll likely tell you that Moody’s was equally awful in forecasting the mortgage debacle.

This is happening shortly after Egan Jones, the other rating agency that had dared to downgrade the US, had been taken care of by the SEC in January who barred it from rating the US and other governments for a period of 18 months.

So Brad may have a point. The question is, should this worry investors or should this make them feel more comfortable.

Mayo42 signing off.