Part 1: Prior Week Market Movers, Other Noteworthy Events Of The Prior Week & Their Lessons For the Coming Week
Markets moved mostly with headlines and speculation about the EU summit, all else was secondary, though there were numerous events that were worth noting.
1. EU Summit
From Monday to Wednesday risk assets traded in a tight range with modest movements up or down. Then came Thursday’s plunge, driven by:
- The ECB’s ending hopes for a big financial aid plan to contain the debt crisis
- Germany’s rejecting key proposals to strengthen the EZ’s bailout fund
Friday’ news didn’t alter this picture.
In sum, the much anticipated summit appeared to utterly fail to provide what markets wanted to see – assurance that there would be all the cash needed to insure against sovereign defaults and the banking collapse and deep recession likely to follow. On the surface
- No quick fiscal integration and prevention of further overspending
- No big new financial bazooka buy GIIPS bonds and thus prevent sovereign defaults
Yet, as of the close Friday, risk assets were rebounding higher, despite any obvious reason for the optimism. Let’s take a closer look at the prior week’s top market movers, and also try to discern why risk assets held steady despite having every reason to sell off.
Falls Far Short of Final EU Crisis Resolution
If this was supposed to be the summit that ended the EU crisis, then the summit was an unqualified failure. None of the steps believed needed to address the root problems were taken.
- No agreement on fiscal integration. Yes, steps were taken in that direction, as the agreement committed the leaders to enacting a “fiscal compact” and to work towards a “common economic policy,” however thus far all we have are these vague phrases. Once again, just another plan to make a plan.
- Details are missing (as usual for EU summit agreements).
- There was nothing thus far stated that suggests enforcement of spending and debt limits will be any more successful than under the Maastricht treaty, which was supposed to do the same thing and was ignored from the start.
- No massive commitment of cash to prevent Spain and Italy from defaulting, which is what markets really wanted to see.
- No Euro bonds.
- No new massive cash injections for bailout funds to prevent defaults.
- Nor will there be any ECB bond buying to put a ceiling on GIIPS bond rates, with ECB President Draghi reaffirming a €20 billion ($27 billion) limit on ECB bond-buying per Reuters.
- No bold new initiatives to spur growth in the GIIPS economies.
Instead, EU leaders will consider enlarging the €500 billion ($667 billion) in funding available to the ESM in March 2012, and lending another to €200 billion ($267 billion) in additional funding to the IMF.
In the end, Merkel and Sarkozy continue to insist that the key to ending the crisis is regulation, while markets are waiting for commitments of cash to prevent default.
Ultimately, we seriously question
- How many nations will truly be willing to cede control over their budgets (and thus effective sovereignty).
- Whether there is enough political will anywhere to come up with enough cash to backstop Italian and Spanish sovereign debt.
Note that Germany remains dead set against any kind of debt liability sharing like that of Eurobonds, and also wants treaty changes to allow member nations to leave. This feeds our suspicion that Germany could ultimately be one of the nations to leave if it can find a way to retain trade advantages of the EU without the burdens of other nations’ debts.
Regardless of how markets may react in the near term, there is no reason to believe the crisis has seen its worst days.
See here for further details
Yet, risk asset markets were up Friday, despite having every reason to conclude the crisis is still very much on. Why?
Possible Explanations for Friday’s Rally
Here’s the possible explanations that I could find.
1. No More Bondholder Losses
Those leaders who had insisted that private sector (financial institutions mostly) holders of sovereign debt bear part of the cost of any bailouts via haircuts (partial defaults) dropped this demand. Many correctly see its introduction last July as the cause of the latest crisis. Why should anyone accept low yields on these bonds if in fact they weren’t virtually risk free?
EU President, Herman Van Rompuy, stated early Friday:
As regards private-sector involvement, we have made a major change in our doctrine: from now on we will strictly adhere to the IMF principles and doctrines,” and added “or, to put it more bluntly, our first approach to PSI, which had a very negative effect on debt markets is now officially over.
So elimination of risk of EU imposed bondholder losses should be great for the banks. But what if, regardless of EU policy, the GIIPS actually can’t or won’t pay anyway? A Greek default is still a matter of if, not when. Once we get one default, others become much more likely as GIIPS yields rise, bank lending freezes up again, etc.
In other words, dropping PSI (private sector involvement) is meaningless for preventing bondholder losses unless there is some new financial “bazooka” to provide the cash when needed to prevent defaults.
2. Crouching Tiger, Hidden Bazooka?
Global Macro Monitor argues that’s exactly the point. By explicitly ending PSI, the EU is implying that public sector bailouts will continue via an implied bazooka whenever the GIIPS need someone to buy their bonds, which are used to repay the holders of maturing bonds.
So why aren’t EU leaders being more explicit? An openly declared bazooka would do a better job of calming markets. In a recent post, the writer offers two reasons:
The earthquake and severe aftershocks that has shaken even the German banking system and has increased global systemic risk has put the fear of God in the EU leaders. They now know what’s at stake but a wholesale bailout of the banks and bondholders is a hard sell to their domestic constituents and parliaments. Ditto for debt monetization and the German public.
The EU may have also learned an important lesson that the markets will surely test any number they put on the bazooka.
Supporting this idea of the hidden bazooka was a line in the EU press statements from Sarkozy, which suggested that the ECB’s move to provide unlimited three-year funds to cash-starved European banks would be more effective [than a big bazooka type bailout fund], by enabling them to continue buying government bonds.
“This means that each state can turn to its banks, which will have liquidity at their disposal,” he said (Reuters).
In other words, the EU may have bought some time, up to 3 years, until the defaults start to role in and cause bank balance sheets to collapse as the value of all those newly purchased GIIPS bonds melts away.
2. S&P Places 15 of 17 EZ Nations on Downgrade Watch
The news pressured risk assets Monday and Tuesday, because if one of the key funding nations (read: France) were downgraded that would lead to a downgrade of the EFSF bailout fund’s credit rating and raise its borrowing costs.
Not Market Moving But Noteworthy
Rising Risks Of QE in the EU?
If in fact there is a planned but unstated big new funding mechanism, is a European version of QE coming with all the long term negative inflationary implications for the EUR and positive short term implications for stocks? That too could explain the Friday rally. Nomura bank thinks so, arguing the EURUSD will fall ~1400 pips from its current 1.34 level to test 1.2000 as the need for large scale QE becomes clear to all. See here for details. If so, would Germany really remain in the EU, given its hard money fervor?
Capital Flight From The EU Continues
“Between a trickle and a flood,” is how one private banker describes the move out of euros into other currencies by the EU’s wealthiest investors. The greenback and the yen are favorites, with London property also popular. But Italy just banned cash transactions over €1K euros. Capital controls coming soon? (via seekingalpha.com)
This movement could ultimately bring either grave threats to the banks effected or capital controls to prevent further outflows, leaving depositors at risk of losing their money when the defaults start, rendering the GIIPS bonds held by EU banks worthless and those banks insolvent.
Capital Flight From France, Italy, and Spain In Particular
Last week The Telegraph reported ongoing outflows from French, Italian, and Spanish banks in particular. Most cash was heading for German, Dutch, and Luxembourg banks.
Bleak Economic Outlooks Continue to Roll In
Commodity giant Cargill is cutting staff. The company can be seen as a bellwether of global economic health, because it’s as tied into the center of global trade as much as any firm on the planet, and unlike publicly held firms, it’s privately held, and so is a little less worried about public reaction.
“Not even in Japan, during its lost decades, did real GDP decline for 6 consecutive quarters,” say Citigroup economists who are forecasting just that for the euro zone. It’s another in a series of bleak forecasts from Citi, whose chief economist, Willem Buiter, is a top table-pounder for the ECB to print the troubles away. (via seekingalpha.com)
Instability in Russia
Putin could only manage a much smaller than predicted victory, despite widespread reports of election fraud. These have brought a steady stream of violent protests and loss of prestige for his party.
Ratings Agencies Missing China Banking Troubles?
Per China bear Jim Chanos “The rating agencies are getting this one really wrong,” regarding why the U.S. and Europe face downgrades while China and its banking sector get a pass. Believing a Chinese economic crash to be imminent, he recommends shorting “anyone involved in the China real estate boom” – from Mainland banks and developers to Australia’s miners.
Preparations For EUR’s Demise Quietly Continue
Some European central banks have reportedly started to weigh their options for a partial, or complete, Euro-zone breakdown. Ireland, for example, is said to be considering whether it needs to buy printing presses in case it must print new notes.
The Swiss are considering alternate currencies to use as a franc reference point.
Also, Swiss Finance Minister Eveline Widmer-Schlumpf told the Swissparliament that a work group was studying the imposition of capital controls and negative interest rates to protect Switzerland from the capital flight that a euro collapse would bring (Handelsblatt).(via businessinsider.com)
Lessons & Ramifications
We continue to regard any rallies as short term. Nothing appears to have changed our prognosis for the continued decline in the EU and globally. A global economic crisis brought on by EU sovereign defaults and banking collapse of epic proportions remains the likely endgame. However with governments justifiably doing all they can to prevent this, timing such an event is impossible.
On a longer term basis we remain short EU exposed assets (most risk assets). Given that some kind of QE appears to be coming to the EU, if not the US too, cash hedges like gold should be bought on dips.
Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.