Draghi's 'Battle With The Markets'

by: Acting Man

A Premature Victory Lap?

"Has Draghi Won the Battle with Financial Markets?" an article at CNBC asks, expressing the hope that he has, but also a bit of unease over the possibility that more trouble may be coming down the pike. Generally, the reportage on Thursday's ECB meeting and the decision to stand pat on the paltry 0.75% refinance rate was similarly tinged across the financial media. With the "battle against the markets" seemingly won, Draghi could now "afford" not to cut his almost non-existent benchmark rate even further toward non-existence. Instead, he could now "keep some of his powder dry," just in case those unruly markets were to pipe up again. The mood is best exemplified by this excerpt from the CNBC article:

Kathy Lien, managing director at BK Asset Management in New York, says investors realize that Draghi's satisfaction with improvements in financial markets means the ECB is less inclined to ramp up stimulus measures.

'With financial market sentiment improving significantly, tail risks removed and funding conditions at satisfactory levels, Draghi believes that the financial markets have now returned to normalcy,' she said in a research note.

'The main takeaway from the meeting is that the ECB is no longer in crisis fighting mode because the battle with the financial markets has been won,' she said. (emphasis added)

Not a word anywhere about the fact that the markets didn't just go into paroxysms for the hell of it, but that the whole unsustainable financial fabric of the modern-day welfare state was for a brief time exposed -- with its ultimate destination revealed.

Whatever would we do if we had no bureaucrats and politicians willing to do "battle" with the markets? The allegedly conservative chancellor of Germany, Angela Merkel, is also regularly outing herself as a valiant enemy of the markets. When it comes to financial markets, we even once learned that there is actually no difference between Merkel and the proto-communist Alexis Tsipras.

Greek anti-bailout leader Alexis Tsipras may share more common ground with German Chancellor Angela Merkel when it comes to financial markets than suggested by his attacks on the austerity she demands.

Tsipras, meeting opposition politicians in Berlin today, sees Europe's financial crisis as 'a war between peoples and capitalism, and Greece is on the frontline of that war,' he told the Guardian newspaper in an interview published May 18.

Contrast that with Merkel, who said in a speech on Nov. 18, 2010, that 'it's true there is a kind of battle over what power the financial markets have and how much room for policy making the politicians have.' At stake is 'what we call the primacy of politics,' she said. (emphasis added)

Readers may recall that this is a topic we tackled already at the very beginning of the crisis (see "The Euro Area Debt Crisis, the Bailout Update" and "Politicians versus Markets").

Undoubtedly, one should not underestimate committed modern-day social engineers and least of all central bankers with their power to create unlimited amounts of money at the press of a button. As can be seen below, the "battle" indeed appears to have been "won" for now:

Five-Year CDS on Portugal, Italy, Greece, and Spain -- No More Worries, Mates!

Source: Bloomberg.

Spain's 10-Year Government Bond Yield: Breaking Below the 5% Level

Source: Bloomberg.

Three-Month, One-Year, Two-Year, and Five-Year Euro Basis Swaps -- No Longer Doomed

Source: Bloomberg.

What is easily forgotten, though, is that economic laws cannot be suspended by the printing press. They can also not be suspended by saddling the tax payers of one part of the euro area with the bill for the mistakes made elsewhere, especially when even the alleged paragons of fiscal virtue among the euro area's governments are in reality for the most part spendthrifts that would have to file for bankruptcy were they forced to adopt private sector accounting practices.

As an aside, the main reason why they don't have to actually adopt such strict accounting practices is that it is implicitly assumed that they can and will one day welch on their promises. Thus, so-called "unfunded liabilities" are a highly hypothetical construct. Since they cannot be funded anyway, they are not really liabilities. The state will one day get out from under them either by outright default or by inflating the currency into oblivion (which "solution" will be adopted will depend on political expediency and the perceived exigencies of the moment).

In any case, the general view today is that the "battle against the markets" has been won. However, while as we have pointed out previously, a number of imbalances in the euro area have indeed been reduced -- specifically the inner-European current account imbalances and competitiveness gaps -- the basic problem remains. Monetary inflation, which was the root cause of the crisis, is employed now as the "solution" to the crisis, similar to the U.S. For a while, this can create the illusion that things are getting better, not unlike the U.S. housing bubble once making it appear as though the problems of the post-Nasdaq crash recession had been overcome. In reality, though, the seeds for the next bust are inevitably sown.

A Neighboring Bubble's Painful Demise

There is one country that happened to avoid the euro, but has been cruising toward disaster anyway. Readers may recall that Denmark's central bank not too long ago cut its deposit rate into negative territory, pretending that the cost of capital should not only be zero, but less than zero, in an attempt to head off misguided "safe haven" flows into the Danish currency as well as propping up a real estate bubble that has begun to crumble some time ago already. The bubble is now imploding at an alarming rate in spite of this interest rate extravaganza that attempts to upend the universal phenomenon of time preference. A bout of financial innovation that the country's banks cooked up to make it possible to finance ever more expensive homes and expand credit long after the pool of credit-worthy borrowers had run out, is coming home to roost with a vengeance:

Denmark's $500 billion mortgage industry is looking at how to keep struggling homeowners afloat as the nation's push into interest-only loans a decade ago now threatens a jump in losses amid rising unemployment.

Loan writedowns for mortgage banks in Denmark jumped 51 percent in the first half of last year, according to a report released last month from the financial regulator.


Loans that allow principal payments to be postponed by as many as 10 years now comprise more than half of outstanding mortgages after being introduced in 2003. Denmark's two mortgage banking groups, whose members include Nykredit A/S, Europe's biggest issuer of home-loan backed bonds, are in talks with regulators on how to help homeowners unable to meet principal payments or refinance into similar loans.

'There's a double interest, to help people and to avoid losses,' Jan Knoesgaard, deputy director of the Association of Danish Mortgage Banks, said in a phone interview. 'It's not that many this year, but more and more homes in the coming years will find their 10-year period is running out.'

Escalating loans losses, coupled with signs interest rates are on the rise, could stall efforts in Denmark, home to the world's third-largest mortgage bond market, to emerge from a four-year slump in its housing market. Home foreclosures jumped to the highest in two decades last year as the economy contracted, even amid record-low interest rates and signs the housing market stabilized. (emphasis added)

Denmark and, in addition, euro area "core" member the Netherlands are both the latest acute real estate bubble implosions, but there are more potential ones waiting in the wings. These symptoms are for now ignored by market participants because these worries seem fairly small (similar to the impending Cyprus bankruptcy) compared to the worries that beset the euro area at the crisis peak to date. However, they are symptoms of a far greater problem -- as there remain a number of similar unsustainable bubbles still extant in Europe (not least in France), while new ones are already forming (in, for example, Germany). The question is not if that will matter, but when.