The Good News: They Got A Plan Before The December 31 Deadline; The Bad News, It Makes Things Worse - EU Crisis Risk Now Higher
In our weekly fxempire.com analysts' meeting, in which we share thoughts and conclusions about the weekly outlook for global equities, currencies, and commodity markets, we noted that the results for the past week's Euro group and ECOFIN meetings', which finalized the details of the long awaited bank reform, the SRM deal (subject to EU Parliamentary approval), were far too underreported relative to their importance.
The following is an update of the 3 part special feature on the coming a single resolution mechanism (SRM - get to know this acronym) for dealing with troubled EU banks.
See part 1 for introduction, background and general themes reflected in the negotiations and terms
See part 2 for summary and analysis of specific key terms, including their risks and dangers
See part 3 for conclusions and the deep flaws we saw in the deal
In this update we'll look at how these flaws have only been exacerbated in the version of the plan that was finalized this past week by a meeting of EU finance ministers.
In last week's post, EU's Coming SRM Deal: 10 Reasons It's Bearish For The EUR, Europe, we concluded that the coming SRM deal was a failure. We cited about 10 reasons (depending how you count them).
We admitted that the deal was not yet finalized and so terms could change during the following week (this past week) during Eurogroup meetings on the 17th, the ECOFIN meetings on the 18th, and the EU summit on the 19th.
Thus we offer an update. We've found a few more very significant problems with the plan
We cited about 10 reasons (depending how you count them). They fell into two broad categories which we'll summarize.
1. SRM Common Bank Bailout Fund Provides Too Little, Too Late: Doom Loop Stronger Than Ever
The chief reason for the deal was to provide an emergency bank bailout fund and deployment process that could be deployed in such quantities and speed that it would banish fears and risks that single bank insolvency could metastasize and spread to an entire national banking system, government, or even beyond boarders to threaten the entire EU's banking system, economy, sovereign solvency, and thus, very existence.
If anything, the new plan strengthens this "doom loop," the link between insolvent banks that can quickly spread that insolvency to the nation's banking system, government, and other parts of the EU.
The new troubled bank funding plan still leaves individual states essentially fully liable for their own banks, and so just as vulnerable as before to being dragged down by a single bank.
Even then, these funds may be too little, too late for the foreseeable future.
EU Common Fund Is Too Little
The entire common fund will eventually reach a full size of 55 bln EUR. As we explained in Part 2, that's unlikely to cover more than one partial national banking system bailout. Thus the minute it's used, it's virtually exhausted and begs markets to start looking for the next bailout risk, find one, and start hiking its borrowing costs to compensate for added risk premium. That would also invite a speculative attack, a massive shorting that could become a self-fulfilling prophecy without new, credible promises of cash that the GIIPS countries can't make without EU backing.
It Will Likely Come Too Late
Even that undersized common fund won't be available for years at best case. It will be built up over 10 years.
For most of the next 10 years, the common fund is so small that it's irrelevant. That means individual states, their banks, depositors and investors remain almost solely liable for their failing banks. Many of the GIIPS nations, which include too large to bail Spain and Italy, may well be unable to stabilize a failed bank before the fear it breeds spreads insolvency to its entire banking system and/or government as markets shun anything connected to it and cut them off from credit needed to survive. (ref salmon's article, note that virtually all states, including those with the best credit ratings, retain that rating not because they actually have the funds to repay their outstanding bonds, but rather because markets assume they can sell new bonds to pay off the old ones. Those that control their own printing press can print for a while, the EU states however, cannot, nor would they be likely able to decide to do so quickly enough in case of emergency.
Common SRM Funds Hard To Access
Even if the funds were somehow available tomorrow, it might not help. As we noted in part 2 last week, there are many steps in the process of accessing common EU funds, in addition to those involved in exhausting private sector and national bailout fund options.
Private Sector "Bail-Ins" Perversely Strengthen The Doom Loop
Even worse, EU member states are now more vulnerable to bank troubles because the new plan, for the first time in EU history, officially enshrines moderately large depositors and most bank stock and bond holders as the first in line to be officially liable to pay for losses of a troubled bank. They must pay before national funds can be tapped, and those must be exhausted before EU common funds can be accessed.
Thus the plan adds the risk of sudden bank runs, bank stock selloffs, and bank lender boycotts at the first sign of trouble. Ironically, the SRM funding plan makes taxpayers more likely to pay for troubled banks, unless EU states are ready to impose long term capital controls that prevent capital from fleeing to safer places.
What else could keep any rational person from risking funds in an EU bank? Even banks in non-GIIPs countries would be vulnerable, given that few know the true exposure of any given bank, direct or indirect, to another bank in the EU.
If capital controls are coming, then why should any rational investor or depositor not start moving cash now?
2. SRM Too Slow, Too Decentralized, To Act Fast Enough
Leaving aside the funding issue, the very decision making process is a bureaucratic nightmare with little chance in its current form of being able to decide anything in the few days needed for dealing with a troubled bank before the uncertainty surrounding who might lose money starts to cause trouble in the form of bank runs, credit freezes, stock market sell-offs, loss of credibility, etc.
Per an FT report:
A Financial Times analysis of the full banking union resolution process for a lender operating in three countries reveals the labyrinthine procedure that would still be required to wind up a bank. In a worst case scenario, where key officials disagree, this could involve nine panels and up to 143 votes being cast, from its supervisor raising a warning flag to the final wind-up decision.
Meanwhile there is no plan to deal with the certain lack of funds for transitional decade ahead while the individual state and common EU funds are built up.
The above are only the most dramatic flaws. To view the rest, see Part 2 and Part 3.
For more background on why the risks and stakes are so high, and why the EU needs the plan to be an unqualified success, see Part 1 here.
After reviewing the finalized version, we've a few more points of concern, conclusions, and thoughts on how to profit from the deal (which is still subject to an EU parliamentary approval that is far from guaranteed).
Last week we noted about 10 reasons the deal was too deeply flawed break the 'doom loop' or significantly centralize and streamline EU bank supervision.
In addition to those mentioned above, some other serious ones include:
· It increases deflation risk as banks cut lending to hoard cash ahead of tests
· It demonstrates that the same old obstacles, fear of ceding sovereignty, funding nations' unwillingness to provide aid to nations that cannot repay debts, etc., remain unsurmountable, and so cast doubt on the EU's ability to solve this or other fundamental flaws.
· There is no backup plan to replenish existing funding for the common EU bank resolution fund, or the individual national funds, if more money is needed during the transition decade (very likely given the current state of GIIPS nations and banks) or beyond. This is avoidable, though not painless, especially for the funding nations holding the Euros that would lose value.
o Most nations favor tapping the ESM fund (technically reserved to bailout sovereign states), however Germany and its fellow funding nations oppose it. That's a problem because tapping the ESM is the best option the EU has unless they're suddenly ok with massive money printing (also opposed by inflation-phobic Germans)
o Tapping the ESM makes sense because a banking crisis most likely IS a sovereign crisis for the GIIPS nations, which lack the normal tools for dealing with such a crisis: cash reserves, an adequate tax base, and an ability to print money.
o Any government facing an insolvent banking system is also facing economic collapse and thus its own ultimate insolvency. So we'd expect it to use its last cash and borrowing power to save its banks, put itself into insolvency, and then threaten contagion risk if they don't get ESM help. If little Greece can keep pulling that trick, so can others. So why not face that fact, and spare everyone and markets a lot of angst (and market crash risk) and agree to tap the ESM. Yes, that might reduce national reform incentives, but the benefits of austerity and forced reforms may have been fully exploited. The GIIPs are not going to start behaving like Germany in the coming years, nor will their finances improve with further spending cuts.
o The EU has ignored other legitimate options for replenishing the fund if needed, including the easiest in the short term, outright money printing. Is the risk of inflation any worse an economic risk for the funding nations than the risk of a wave of GIIPS insolvencies that could easily drag down most or all of the EU and bring global recession?
Reviewing this week's finalized version, we see a few more.
11th Reason: EU Parliament Must Approve, But May Not
Even the very flawed plan approved by EU finance ministers may not get Parliamentary approval, as the EU Parliament not only sees the same flaws, it also has its own plan that differs from that of the one the finance ministers have approved.
Still, the parliament may have no real alternative but to accept the plan, given that it was designed to be acceptable to Germany and its fellow funding nations whose support is essential.
See here for details.
12th Reason: The Failed Plan Risks Awakening EU Fears
It shows the same problems that prevented the EU from acting quickly and effectively remain today.
Reluctance to cede sovereignty that translates into requiring approval from too many individuals and committees, bureaucratic process too slow to deal with crises.
Funding countries remain unwilling to be liable to transfer their wealth to weaker economies
Cultural differences and lack of trust hamper EU's ability to Unify
13th Reason: ECB Stress Test Validity In Doubt, Thus Bank Unification Too
Without a credible backstop for EU banks the ECB cannot afford a truly robust banks stress test, because that would risk exposing bad banks without a solution for them, and risk reviving the EU crisis by exposing and estimated 70-90 bln euro in capital caps for which there is no clear resolution.
Without a clear picture of which banks need help and how much of problem the EU is taking on, it's likely the EU could freeze the whole bank unification process rather than risk getting stuck with a bill like that.
That means the bank reform process stops, and the EU loses more credibility and market confidence. We won't add that to our list reasons this bank deal is bad for the EU and EURO, as it was already mentioned in our prior post in Part 1.
It's no accident that once the terms of the EU finmins' bank deal was announced, the S&P stripped the EU of its AAA rating due to the "overall weaker creditworthiness of the EU's 28 member states," as well as on concerns about budget talks.
14th Reason: Final Plan Confirms Germany's Right To Avoid Paying
We noted this problem earlier, but hoped that the final version would eliminate it. What is the point of watering down so much of the originally intended powers of the pact to please Germany, if, even after all that, Germany retains the power to walk away and cast doubt on even the limited benefits of the plan?
Conclusions and How to Profit, The Bright Side
It can be argued that the deal is at least a partial success because it's a starting point from which to progress.
The Reality: EU failed
That's true, but it's a small comfort considering that the EU has:
· Clearly failed to do what it admitted it needed to do - diffuse the contagion threat posed by the numerous bad banks in the EU
· It has made the problem worse by officially establishing bank depositors, shareholders, and bond holders as the first ones to be liable for troubled banks, and thus made those parties most needed the most likely to flee at the mere hint of trouble.
The Winners From This Failure
Until capital controls are imposed in a given state, we can expect capital to flee from riskier to safer havens.
Those banks that fit the following criteria will be seen as safe havens:
1. Domiciled in the most financially stable host nations
2. Domiciled in the most systemically important host nations
3. Bank itself is both financially stable and systemically important
4. Host nation has option to print money in an emergency (certain EU nations, but no EZ nations qualify)
Similarly, currencies from those nations should be in greater demand, as well as the traditional safe haven currencies like the USD, CHF. The JPY is also a traditional safe haven, though one's belief in it depends on one's belief that Japan's radical monetary policy experiment (aka Abenomics) will avert what many see as inevitable disaster at some unknown point in the future given what appear to be unsustainable debt levels. We have written about these often in the past.
The above list means top banks in Denmark, Sweden, and the UK stand to gain, as do those from other relatively strong economies with a printing press, such as the US, Canada, Switzerland, Norway, etc.
The most systemically important banks in the most systemically important AND financially stable countries are likely to be viewed as safe-havens and attract capital that flees from weaker banks and nations.
The losers are, to varying degrees, virtually everyone invested or living in the EU, especially those in the GIIPS nations, and other nations that suffer from both weakening economies and high exposure to GIIPS or other peripheral European economy debt. France, the EU's #2 economy, is the first to come to mind, but the same can be said for others.
Obviously the future of the EU itself, and the EUR, remains in as much doubt as before. Now, however, markets have gotten their first big reminder since the summer of 2012.
The EUR's recent gains are still within an overall downtrend relative to the USD. Add that technical issue to the fact that the Fed is, albeit slowly, moving to tighten, and the ECB is likely moving in the other direction, and it's clear that the long term EURUSD trend lower is likely to remain intact.
Caution On New EURUSD Shorts
That said, we are NOT advocating new EURUSD shorts at this time. Here's why:
The medium/long term trend on the weekly EURUSD chart remains up, and shows entrenched momentum - we respect that technical strength until we see enough evidence of a reversal.
Eurusd Weekly Chart 18 March 2012 - December 20, 2013
01 dec 220114
Obvious momentum indicators include:
1. The uptrend dating from July 2012
2. Price remains in its double Bollinger band buy zone (to understand why that's a significant indicator of continued upward momentum, see 4 Rules For Using The Most Useful Technical Indicator, Double Bollinger Bands.
3. All weekly exponential moving averages (EMAs) trending higher, with short term EMAs mostly above the longer term EMAs. That implies strengthening momentum. See my book, Chapter 8, for a full explanation (you can view some of that for free online here using amazon's "look inside" feature.)
My quick and dirty real time indicator of retail trader sentiment, the EURUSD long/short ratio of a sample of retail traders with average holding positions of 8 weeks (medium-long term traders, not day traders) on forexfactory.com, shows 67% of EURUSD positions are short vs 33% long, as shown in the chart below. That's the typical positioning for the past few months, already a crowded short despite the firm uptrend. COT reports show a similar over weighting.
Real Time Daily Chart Of A Sample Of 400 Retail Traders October 14, 2013 - December 20, 2013
Source: forexfactory.com, homepage
02 dec 220300
The bottom line is there is no reason to start short positions for the long term until the long term trend shows us strong signs of reversing.
No Substantive Reforms Likely Until A Crisis, But Then May Be Too Late
Once again, it appears that the EU has little chance of serious reforms until it hits a crisis (which of course could also kill it).
As noted here:
So, how did the EU summit flag so quickly? Chancellor Merkel knows the answer and even casually mentioned it in one of her press conferences: the financial markets set the pace. And because the markets have been quiet for several months now and no attack on the crisis states of the Eurozone looks imminent, the willingness for reform in the EU has suddenly come to a grinding halt.
Experts warn that the financial crisis has not yet been solved, that it is only halfway under control and that it can flare up again anytime. But apparently that doesn't motivate the European heads of state to do something. They just want to get by in the coming months. First they want to pull off the elections for the European Parliament without much drama. Then a new EU Commission will be put in place.
…However, this pre-Christmas calm could be deceptive, because at one point the European voters, who are supposed to vote for a new parliament in May, will realize that the heads of state have no answers and no recipes for the future.
Profiting And Protecting Yourself From The Currency Wars
Overcapacity is keeping inflation low, but that won't last forever.
Meanwhile most of the largest economies' central banks are either likely to ease further (ECB, RBA, BoJ) or maintain dovish policies (Fed, probably the BoE in the long run too).
These facts suggest that the USD, EUR, JPY, in addition to other major currencies, are likely to be bad stores of value.
Those based in USD have suffered from wealth leakage from a weakening currency for decades. See 7 Charts Tell Why We All Need Currency Diversification for the full story.
See here for other lessons to remember for the coming week as well as posts summarizing last weeks market action and its drivers, and coming week market movers.
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Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.