Yesterday Once More

To suggest that this is a rather pivotal week for the global financial markets and economy is an understatement. We all know that the Eurocrats have in the perception of the markets dragged their feet for far too long in terms of attempting to both resolve short term financial market pressures as well as restore confidence in the system. The fact that “the system” itself is flawed lies at the heart of the equation, but that’s not about to be fixed, if you will, any time soon. This will be a continuing story in the tomorrows of our life. In fact, for all the hemming and hawing by the German contingent about the potential inflationary dangers of excessive monetarism, when faced with the choice of a Euro currency implosion versus the perceived evils of currency debasement/inflation, the Germans will choose to save the Euro. Make no mistake about it. In fact, in good part isn’t this exactly what the current week’s machinations are all about? On a bottom line sense, indeed.

I think it’s appropriate that we think and act in time frames. Quick explanation. As I’ve contended for many a moon, the generational and global credit cycle will ultimately resolve with a series of sovereign debt crises. Personally, I believe we’ve already embarked upon this very path. But the path will take short term twists and turns and the story needs time to fully develop and play out. In fact, as exactly the Euro drama of the moment is hinting to us, we’re still in the first few acts of the greater cycle drama end game as the global consensus still believes that all problems can be “bailed out”. We’re nowhere even near having priced in an alternative scenario. Again personally, I’m convinced that this perceptual notion of perpetual bail outs will be dispelled before the final curtain falls on the generational credit cycle reconciliation process, but we’re not there yet. This disillusion of perpetual bailouts may be the most important perceptual shift yet to come in this cycle process with direct implications for investment decision making, but all in good time.

So for now, investors await/demand their consensus expectations of bail out to be realized once again. It’s yesterday...once more. In terms of time frames, the issue of resolution for the nominal magnitude and the relatively intractable nature of global leverage still remains a story for tomorrow. But with each coordinated Central Bank intervention, this story of tomorrow comes just a bit closer to today. Without question the Central Bank swap announcement of last week was in response to deepening problems.

Was a large Euro bank on the ropes last week? Very good probability as more than a fair number of very large Euro area banks are quite dependent on dollar funding. I have written in the past about US money fund exposure to Euro banks. That has changed dramatically over the past six to nine months as money funds have shunned Euro bank paper, a formerly critical source of dollar funding to these banks. And it’s not like global institutions have been beating down the doors to load up, completely the opposite. So it’s no wonder Euro bank dollar funding hit a huge rock in the road. But at least for now, the Central Banks are dug in because these former Euro bank paper buyers are not coming back any time soon.

The circumstances of Europe are meaningful and very intimidating. By the way, in a prior lifetime bank runs occurred with a long line of depositors winding blocks down the street. Today? Much less “messy” as the global capital markets take care of it all digitally. Go green? But for now all of this is somewhat beside the point in terms of navigating the very short term. The very near term message by such a public CB showing as was seen last week is clear, global central bankers have chosen to again attempt to reflate the system. For now, bail out consensus thinking is simply being reinforced. Now that global central bankers have stood up and spoken publicly, there will be no turning back.

So in terms of progression, last weeks actions once again addressed liquidity. What the markets will be looking for by next Monday is something addressing solvency (of the banking system). The CB sponsored liquidity promise buys the Eurocrats a bit of time, but the markets are going to need to see a plan in which they can truly believe if even for a while. If I had to literally guess, it will be a plan for strict austerity (taxation and spending targets) for Euro members, but with a target “due date” for compliance far out enough for investors not to immediately want to price in an adverse outcome. In conjunction, the easy way out for Germany is to agree to some form of a Eurobond in return for fiscal target compliance (which will of course be measured at a “later date”). I know I sound like a nut when I say this, but I fully expect the Fed to be involved along with the ECB/Euro crowd in ultimately being a part of some type of total Euro area (banks/governments) funding as the numbers are simply too large for Europe alone, but not now. A major Euro bank problem would absolutely be a problem for US banks, hence Fed attention. Direct Fed involvement will not come by next Monday and it’s very doubtful the Fed will strongly hint at QE3 in the FOMC meeting next week (too many economic indicators have turned up and financial markets have been boosted with Euro fix anticipation). Nonetheless, it’s clear reflation will be supported in a global CB effort.

Wither the equity markets? It goes without saying that watching market reaction to an ultimate “plan” post this weekend will be quite the important task. There has certainly already been a fair amount of anticipation and the CB announcement only heightened expectations that once again “the fix is in”. Moreover at this time of the year, performance remains front and center in terms of the institutional money management community. As of the close last week, the major equity averages have at best delivered a pittance in terms of YTD 2011 returns. Will it be a run for the roses if indeed the markets are promised new “liquidity”? Promised Euro bank backstops? Remember that we have a ton of underinvested and underperforming hedge as well as mainline managers amongst us. IF the markets are promised definable reflation by the Euro crowd itself (as the global central banks have already chimed in), it may be up we go with many a money manager forced to jump aboard. We’ll just have to see how it all turns out. But to me this is the importance of compartmentalizing investment life into time frames. Longer term sovereign debt issues loom incredibly large. This story is far from over. Short term it’s all about liquidity, continuing the perceptual consensus belief in bailouts, and the perception of immediate outcomes being less bad than imagined even a few short weeks ago, the three key variables of the moment.

If you don’t mind, I’d like to spend a just few minutes on China. To myself, the most important news last Wednesday was not the central bank intervention/liquidity support, it was the drop in Chinese banking system reserve requirements. Yes, this was in coordination with the swap announcement, but I think the message is much larger. Okay, first, reserve requirement reductions do not happen in “one’s”, they happen in a series. That’s the direct message of historical experience. This is the first such action by China in what may be a series of three or four (or more) reserve requirement reductions that perhaps stretch over the next year. Let’s keep this simple. Step back and have a look at the Shanghai index longer term.

Of course the Shanghai currently sells at well less than half its high of late 2007, quite the character difference compared to the US equity averages. Moreover, and again unlike the major US averages, the Shanghai closed last week near its lows for the year, having given back a major portion of its post September rally. The two Chinese manufacturing indices (private sector and govt.) reported last week showed us contraction, as did the service sector number reported after the close last Friday. China is not just responding to Europe, but primarily to its own internal economic circumstances that are slowing markedly. Let’s face it, inflationary pressures inside China have moderated a little as of late giving China a bit of monetary breathing room, but it’s clear the Chinese powers that be see greater social risk in economic slowing than in the negative influence of higher inflationary pressures to have taken this action.

We’re at the beginning of Chinese reserve requirement reductions, not the end. This will not be a one off event. Remember, reserve requirement reductions outweigh simple interest rate reductions in terms of potential stimulative effect. RR reductions have the impact of immediately creating excess reserves in the banking system. Excess reserves that can be used for lending or investment. Historically, RR downshifts have been bullish for equities. The other clear message of the Chinese action is that the consumer economy developing in Chinese is nowhere even near the magnitude needed to offset manufacturing/export sector weakness. Remember that Chinese stimulus unleashed in 2008/2009 was multiples of GDP as compared to what was done in Western economies. China does not fool around.

So does all of this tell us that over the short term yet another wave of reflation/liquidity will be released by global central bankers? As always, we need to remain open and flexible in decision making over the short term. Anything can happen. Over the very short term, liquidity and the perceptual consensus cult of bailouts will trump the larger cycle sword of Damocles that is the magnitude of sovereign debt globally. If indeed Europe can put forth the semblance of a credible roadmap over the next week or so helping to ally fears of Euro financial sector refunding needs looking dead ahead, just how will under invested and under performing money managers act? That’s the question.

In closing, one last chart to keep an eye upon. Since very significant global central bank intervention really began back in 2009, gold has shown us an almost perfect series of higher lows. As of early 2011, we’ve come down to kiss the rising bottoms trend line eight times. But as the Euro crises has heated up in mid-to-latter 2011, the bottoms in gold have come well above the longer term rising bottoms trend line. So here’s the important issue. Amidst what is a clear upshift in global central bank attention and accommodation as of the present, will gold see a corresponding technical upshift that these higher bottoms as of late have been hinting at? I’ve drawn in the blue dotted lines that may indeed represent this potential upshift, we’ll just have to see how gold responds to the increased accommodation that lies ahead. IF this upshift in the technical price of gold develops, we’ll be moving up and out of the multi-year trend line drawn n the chart. Stay tuned.