What to make of last week? The events were certainly tumultuous and the fireworks haven't ended.
Let's start with Europe. First, we saw coordinated central bank intervention by providing USD liquidity to European banks. As Alistair Osborne of the Telegraph points out, central banks do not take this kind of action unless something is up.
Central banks don’t do that sort of thing unless something is up; and something is most certainly up. In the eurozone, an unfolding Greek tragedy is careering towards its final, brutal act. And, in our joined-up, global economy that spells trouble everywhere, with the odds shortening by the day on a return to recession.
So, are the central banks signalling Credit Crunch Mk 2 and a rerun of all those hilarious jokes (What’s the difference between an investment banker and a large pizza? A pizza can feed a family of four)? Well, yes and no. They could be signalling something worse.
This is a sign of something very, very bad on the horizon. How bad? A recent poll of economists put the odds of a eurozone breakup at 50%.
An even worse sign is how the stock market shrugged off the effects of this coordinated central bank intervention. The chart below shows the price action of the bank sector against the market. One day after the news of the big intervention, banks stocks underperformed the market. Contrast that to the price action of the sector when Warren Buffett came in and bought into Bank of America.
click to enlarge images
Over to you, sovereigns!
Central bankers appear to recognize that the world is again teetering at the edge of a cliff. They are trying to get ahead of the curve by taking action, but there are constraints on what the Fed, the ECB and other central bankers can do. Central bankers can provide liquidity to the banks, but they cannot provide solvency to the system. (See my discussion here on the difference between banking liquidity and solvency.)
Can Europe hang together?
The meeting of eurozone finance ministers in Wroclaw, Poland was a sign of how dysfunctional the EU has become and how the EU has lost all political cohesion. Where to start? Consider this summary of the meeting from the BBC.
Tim Geithner lectured the EU ministers the importance of political cohesion. "Either you hang together or hang separately", he told them. What was the response? The ministers told him to butt out of European affairs. So, forget about any prospect of Euro-TALF.
What about the Greek collateral issue? They can't even say the same thing at the same press conference! Olli Rehn, the EU Commission for Economy Policy stated, "Concerning collateral I refer to what Jean-Claude Juncker said previously. We are in progress and I trust we can soon get this issue out of the agenda."
Evidently Finland's minister Jutta Urpilainen hadn't read the same briefing memo: "Unfortunately I don't see that we can find a solution tonight."
German Finance Minister Wolfgang Schäuble went on to put the kibosh on the prospect of Euro-bonds: "It is completely clear that we must solve our problems on the basis of existing treaties. Treaty changes take time."
Olli Rehn was more diplomatic, but is this the European version of the Japanese answer of "we will give the matter the greatest of consideration"?
The first step will be a feasibility study with the Commission in the course of this autumn. In this study we will assess alternatives for euro bonds and we will dig deep into the economic and legal issues connected to the possible introduction of euro bonds.
For me a necessary condition of any possible introduction of euro bonds is a further reinforcement of economic governance in Europe, implying sustainability of public finances and sustainability of economic growth models in Europe.
Otherwise euro bonds will turn into junk bonds and that will not benefit anybody.
The story gets from bad to worse. At about the same time, the news came out that:
- Greece is backsliding on its austerity commitments.
- Portugal has under-reported its debt to the tune of 0.3% of GDP, or more.
So what do the eurozone ministers decide? They agreed to delay the decision to give next round of aid to Greece approved to early October. The aid, if approved, would be for disbursement in mid-October and conditional on Greece meeting its targets. This puts an incredible amount of pressure on the Greek government to comply with even more draconian measures of austerity.
All European politicians are caught in a bind because they need to make highly unpopular decisions. For the Greeks, further austerity can only lead to more political unrest. This study shows that budget cutbacks of more than 5% of GDP greatly heightens the risk of protests, general strikes, assassinations and chaos. At the extreme, it can lead to revolution. The Polish finance minister warned last week that a eurozone collapse could lead to war.
On the electoral front, Denmark recently elected a new government that campaigned on a platform of tax increases and increased public spending - which is contrary to the wave of austerity sweeping Europe. The bailout of the Club Med countries is incredibly unpopular in Germany and Angela Merkel must be aware of that as her party recently suffered an electoral defeat in her home state and got crushed in another one in Berlin over the weekend.
The end game for Europe
These events scream the loss of European political cohesion. Everyone out for themselves. Don't expect the EU to come together with a sensible package that gets them out of this mess without a crisis. That leaves the following possibilities:
- Greece takes one "for the side" by implementing the austerity package and stays in the euro.
- Greece defaults and leaves the euro.
- The EU engineers an orderly default for Greece. On the weekend, eurozone finance ministers agreed that European banks need recapitalization, which is a constructive first step.
- The EU tries to muddle through with a series of aid packages for Greece in order to kick the can down the road, knowing that it will lead to eventual default (see 2).
- The EU countries all agree cede power to a greater centralized authority. Such a change will require constitutional change by all member states.
By the way, don't expect China or other BRIC countries to come to the rescue. Patrick Chovanec has a good commentary here on why China is unlikely to be the savior. Don't forget China's mercantilist tendencies. Any Chinese investment into the eurozone may be just their way of stabilizing the EURCNY exchange rate.
Peter Boone and Simon Johnson summarized the European dilemma well here. They concluded that there are no good ways out [emphasis added]:
Expect a great deal of shouting behind the scenes at the highest level in Frankfurt (ECB headquarters) and in European capitals. Instability seems unavoidable. Significant inflation may also follow – although first we will see serious recessions in the troubled European periphery, a ratcheting up of bond buying, and repeated political crises.
The US cavalry to the rescue?
Can the United States be the savior of Europe? Earlier in the week, there was some speculation that Tim Geithner might present some ray of hope to the Europeans with funds, instead of just suggestions on how they might fix their problem. Alas, no money is forthcoming. There is simply no appetite on the fiscal side for any stimulus, even for the US economy.
The Fed is the wildcard.
Doug Short reported that the latest release of the ECRI Weekly Leading Index shows it plunging again and ECRI head Lakshman Achuthan stated on NPR that there is a high risk of another recession. This would give the Bernanke Fed cover to act decisively.
ZeroHedge reported that even uber-bear David Rosenberg is expecting Fed action on Wednesday beyond Operation Twist. In last Friday's edition of Breakfast with Dave, he wrote that Bernanke watches stock prices as a measure of the effectiveness of Fed policy:
Even the casual observer can have no doubt, then, that FOMC decisions move asset prices, including equity prices. Estimating the size and duration of these effects, however, is not so straightforward. Because traders in equity markets, as in most other financial markets, are generally highly informed and sophisticated. any policy decision that is largely anticipated will already be factored into stock prices and will elicit little reaction when announced. To measure the effects of monetary policy changes on the stock market, then, we need to have a measure of the portion of a given change in monetary policy that the market had not already anticipated before the FOMC's formal announcement [emphasis added].
Rosenberg believes that Bernanke is more likely to act now rather than later, because "the more he does now means the less he has to do later during the election campaign" and "he has the support from enough FOMC votes, including regional bank chiefs like Evans from Chicago, to be aggressive". He concluded that Bernanke needs to give the stock market a positive surprise on Wednesday:
[I]f Bernanke wants to juice the stock market, then he must do something to surprise the market. 'Operation Twist' is already baked in, which means he has to do that and a lot more to generate the positive surprise he clearly desires (this is exactly what he did on August 9th with the mid-2013 on- hold commitment). It seems that Bernanke, if he wants the market to rally, is going to have to come out with a surprise next Wednesday. If he doesn't, then expect a big selloff.
What kind of surprise? On Thursday, Rosenberg speculated about extreme measures available to the Fed by pointing to Bernanke's famous helicopter speech of November 21, 2002 [emphasis added]:
The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.
I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar.
Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly.
Given that the Fed participated in coordinated intervention last week, Bernanke must be worried. Indeed, the WSJ reported that the US financial system is highly exposed to Europe [emphasis added]:
If there is any doubt on this score, all one need do is consider the U.S. financial system's massive exposure to the European banks. In a recent survey, Fitch found that, as of the end of July, the U.S. money-market industry still had direct exposure to European banks of over a trillion dollars—or roughly 45% of money markets' overall assets. The Bank for International Settlement reports that American banks have loan exposure to German and French banks of more than $1.2 trillion.
Of course, all this moves are highly speculative. Even if any announced measure is likely to have limited effect, equity markets are likely to rally on the news of a positive surprise.
The week ahead
Here's what I am watching for for the week to come:
Monday: The Budget Committee in Germany's Lower House of Parliament will debate the EFSF expansion and Greek bailout. Watch for what comes out of those discussions.
As well, Greece updates the Troika (EU, ECB and IMF) on the progress of the implementation of the austerity package by conference call. The Troika has decided on not going to Athens. If the aid is not forthcoming, then the Greeks will run out of money around October 10. As I write this, the Greek cabinet is reportedly holding weekend emergency meetings in order to ensure that its budget in compliance with the Troika criteria. The EURUSD exchange rate is down about a penny and ES futures are deeply in the red.
Tuesday: Greece has bond payments totaling €769 million due.
Wednesday: The FOMC will announce its decision after an extended two-day meeting.
Get ready for the fireworks. My inner trader is wincing at the prospect of volatility of more up and down 2% days. My inner investor tells me that anything that the Fed does is likely to be a sideshow. If the Fed were to announce an unexpected round of stimulus, the markets may rally, but the final resolution will depend on how the European sovereign crisis is resolved.
Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
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