The Markets Got It Wrong

Includes: FXE
by: Shareholders Unite

Stock markets turned for the worse on Wednesday, something that is puzzling us a little. First, there was quite good news out of Italy, which sold 9 Billion euros of bills. What's more it did so at greatly reduced interest rates:

The Rome-based Treasury sold the 179-day bills at a rate of 3.251 percent, down from a 14-year-high of 6.504 percent at the last auction of similar-maturity securities on Nov. 25. Investors bid for 1.7 times the amount offered, up from 1.5 times last month.

This is the first concrete evidence that the ECB's three-year support program for banks is actually working, at least for bonds with limited maturities.

The auction was Italy’s first since the ECB offered 489 billion euros in loans to European banks last week in a bid to avoid a credit crunch. Italian lenders borrowed 116 billion euros as part of the tender on Dec. 21, according to a person with direct knowledge of the loans.

The problem with the eurozone is that investors and bank depositors do not have to have any reason to invest domestically or deposit funds with domestic bonds. Investors and bank depositors from Greece, Portugal, Italy, Spain, and the likes can easily transfer their funds to Germany or other eurozone countries without incurring any exchange rate risk.

This they have been doing at a substantial pace, bleeding the periphery dry of funds and bank deposits and creating a credit crunch in the process. This is extremely unfortunate, as the eurozone as a whole only has a budget deficit of some 4% of GDP (compared with 10% in the US and more than 8% in the UK and Japan), but these capital flows out of the periphery make otherwise quite manageable deficits (bar Greece, and to some extent Portugal) into a severe crisis.

Basically, the eurozone as a whole doesn't have an external deficit so it has savings enough to finance all public deficits and debt redemptions, but these savings do not end up there where they're most needed. In fact, quite the contrary, they end up where they're not needed, creating nasty, self-fulfilling feedback loops.

The European Central Bank (ECB) is trying to keep the banking system going and, as many suspect, provide banks with means to buy sovereigns in the periphery in an attempt to stop the stampede out of these. Wednesday morning provided the first concrete sign that this strategy could be working, halving the yields on Italian notes.

And then during the morning the markets turned, especially the currency markets, with the euro sharply down. Bloomberg provided a curious rationale:

The euro dropped against the yen to almost the lowest level since 2001 as the European Central Bank’s balance sheet soared to a record after it lent financial institutions more money last week to keep credit flowing.

There are a number of aspects to this statement. First, the balance sheet of the ECB. Indeed that soared, what do people expect when they provide an almost frozen banking system with near unlimited liquidity? And what's the problem here? It isn't that inflation is likely to take off anytime soon.

Secondly, many (including us) have clamored for a more aggressive ECB stance as basically the only way to keep the destructive effects of these perverse, self-fulfilling capital flows somewhat at bay. This should be good news, there aren't any other ready solutions around the corner.

Third, financial markets sold off on the euro depreciation, but what's wrong with that? That should be good news as well. The eurozone teeters on the brink of recession. A recession would quite exacerbate the crisis by making any debt consolidation that much more difficult. Any economic impulse the eurozone can enjoy should be good news for the world economy, even if it comes at the cost of other areas (that is, other currencies against which the euro is depreciating).

Of course, a bigger test awaits on Thursday, when Italy is auctioning off longer debt maturities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.