The Dog That’s Not Barking

Mon, Aug 13, 2012 - 10:36am

The “go ahead, make my day,” Draghi “will do everything to save the euro” rally saw Spanish and Italian stocks jump 10.6% and 9.5%, respectively, in six sessions. The S&P500 rose 2.0%, with the Goldman Sachs “Most Short” index surging 7.4% (in six sessions). Spain’s two-year yields sank 160 bps in four sessions and Italy’s fell 100 bps. Crude, gold and commodities popped. Somewhat the dog that didn’t bark, the euro closed today at 1.2252, up little since Draghi’s comments and only about 2% above recent trading lows. Spain’s 10-year yields ended the week at a problematic 6.85% and, at 5.88%, Italy’s 10-year yields were only somewhat less discouraging.

There appears to be a meaningful shift in market thinking regarding global monetary stimulus. Recent events have further (it that’s possible) emboldened those believing that policymakers will do everything to backstop global risk markets. To be sure, the “risk on, risk off” dynamic has become only more dominant. Draghi’s Plan may have done little to bolster the euro, but it did incite another powerful “rip your face off” short squeeze in many risk markets. Policymakers may very well take satisfaction in wielding such extraordinary market power, although there will be a heavy price to be paid for interventions that feed increasingly unwieldy markets. And, by the way, it’s also apparent that monetary policy is having waning effect on real economies.

Actually, it’s no coincidence that policymaking takes an increasingly commanding role in global markets even as policy measures show diminished economic impact. And that’s a fundamental bullish tenet of the “risk on, risk off” speculation phenomenon: The greater the economic and systemic risks, the more powerful the policy liquidity response available to stoke global risk markets. Market participants grapple with the question of how long this game will continue working so well.

Data out of China this week was unimpressive. Bank lending slowed sharply from June (to $85bn from $150bn). Weakness was apparent in industrial production, retail sales and housing transaction volumes. Most alarming was the sharp slowdown in exports. At a positive 1% year-over-year, July export growth sank from June’s 11% and was significantly below expectations of 8%. And with exports to Europe down 16%, this data point is one of the clearest indications yet of how the rapidly deteriorating European situation is hitting China. An article from Friday’s Wall Street Journal, “Trade Slowdown Squeezes Asia”, did a commendable job of describing how “the slowdown under way in China is already rippling across Asia…”

There’s a common perception in the marketplace that Chinese authorities can flick a switch and reflate their economic boom on command. I have tried to make the case that China – and “developing” economies more generally – are in an altogether different circumstance these days than they were back in 2008/9 (fragile instead of robust, from a Credit Bubble perspective). Importantly, these Credit systems and economies were previously enjoying robust inflationary biases. As such, “developing” systems proved extraordinarily responsive to stimulus measures – and were well-positioned to assume the desperately needed role of global locomotive coming out of the ‘08 crisis-induced global recession. I see only added support for the view that “developing” financial and economic fragility will be one of the big surprises unearthed by the unfolding “European” crisis.

Especially in China, as the downturn gathers momentum, markets confidently anticipate aggressive stimulus measures. A Bloomberg headline captured the sanguine mood: “Slide in China’s Export Growth Increases Odds of More Stimulus.” Deteriorating economic fundamentals have been the first surprise to the bullish consensus view, and a tepid response to stimulus measures will likely prove the second.

The impotence of post-Bubble stimulus measures remains solidly on display here in the U.S. I have not been as bearish as others on near-term U.S. economic prospects. Yet it’s ominous that zero interest rates, the nationalization of mortgage Credit, massive Federal Reserve monetization and market interventions, and 8-10% annual fiscal deficits equate to such a feeble recovery.

Throughout Europe, things proceed methodically from bad to worse. Spanish and Italian economic data, in particular, continue to be depressing. Meanwhile, it is increasingly apparent that the German economic juggernaut is showing the region’s ill-effects. Market participants pay little attention to the data, though, as they now wait anxiously for the unveiling of the game-changing Draghi Plan. Many anticipate the positive impact a new liquidity push could have on securities prices, although few expect much help for the real economies.

But the cautious consensus view believes that the Draghi Plan at least protects against “tail risk.” Cleverly, the ECB bought a few weeks by assigning details of the plan to various committees. This was sufficient to run the bears, reverse risk hedges and, again, run things amuck for so-called “market neutral” trading strategies. And especially now that the Merkel government is viewed as having capitulated, Mr. Draghi is thought to enjoy a window to pursue more open-ended Fed-like quantitative easing. Moreover, with an isolated Germany holding only one vote in a newfound, majority-rules ECB, the hope is that the Draghi ECB can finally move decisively toward assuming the role of buyer of last resort for European (for now, chiefly Spanish and Italian) debt.

The Draghi Plan could very well support European debt markets. Yet I really struggle with the notion of the ECB as savior for the euro. Desperate central banks are easily more apt to hurt rather than help their currencies. In a crisis environment, a central bank often must choose between flooding a system with liquidity to bolster debt and asset markets - or instead restrain liquidity creation in hope of stemming capital flight and stabilizing the value of its currency. Mr. Draghi would like to tough talk both securities markets and the euro higher. But European policymaking credibility is badly depleted. So markets will force his hand into coming with a substantial bond-buying strategy. Such a plan risks liquidity abundance fanning problematic capital flight.

And this gets back to The Dog That’s Not Barking. The euro has thus far struggled to retreat from the precipice. I have speculated that there are likely huge derivative trades written to provide protection in the event of a major euro decline. It’s reasonable that significant “insurance” has been written at the 1.20, 1.15 and 1.10 (to the dollar) strikes. If correct, this analysis infers that potentially enormous selling pressure might be unleashed if the euro falls much below current levels.

European economies are spiraling downward, and I expect economic activity to remain largely impervious to monetary stimulus. I don’t believe the Draghi Plan will reverse the crisis of confidence in eurozone debt or the European banking system - or meaningfully loosen Credit conditions. And, as I mentioned above, I fear a desperate ECB may increasingly jeopardize the euro (see Mr. Issing’s comments below). Mr. Draghi invoked “convertibility risk” as justification for monetizing government borrowings. Such measures, however, will not allay market fears regarding the sustainability of the euro currency. Increasingly destabilizing capital flight remains a serious risk.

Interestingly, (former Bundesbank and ECB Chief Economist) Otmar Issing maintained a high-profile this week. He was interviewed by Dow Jones/The Wall Street Journal, and then appeared live on CNBC. He said little that markets would find comforting, although participants to this point have been dismissive of his influence. This week only added to my suspicions that Mr. Issing and some of the old guard from the Bundesbank may feel the situation has deteriorated to the point that they must become part of the debate.

From the Wall Street Journal (8/9/12 – Christian Grimm): “Mr. Issing said that from a historical perspective Germany indeed is ‘in a special position’ but 67 years after the war ended ‘Germany can’t be blackmailed with its past,’ he said. This is especially true of aid for troubled euro zone states, ‘which does not solve the problems in these states…’ Mr. Issing said it was wrong to expect the European Central Bank, tasked primarily with maintaining price stability in the euro zone, to step into the breach and buy the bonds of troubled euro zone states. ‘This does not solve the problems and is not legitimate,’ he said, adding that it violates EU treaties… Mr. Issing rejected the idea that any country could stay in the euro zone at any price. This ‘creates the possibility of blackmail. The participation in the shared currency must be permanently earned,’ he said.”

And from Issing's forthcoming book: “The less politicians address the root of the problems, the more they look with their expectations and demands to the ECB, which is not made for this. It is a central bank and not an institution to rescue governments threatened by bankruptcy. A central bank always also acts as a lender of last resort for the banking system - but it does not rescue governments.”

From CNBC (8/10/12 – Silvia Wadhwa and Catherine Boyle): “‘A break up of the euro area would be a major disaster – no doubt about that. But the alternative to that, [is] being a monetary union in which the reputation of the ECB would be undermined, or even destroyed. The euro would tumble and governments would pile up debts without any limit. I think this is a scenario – a horror scenario – which comes close to the disaster of a break up… The euro itself does not need to be saved. What has to be saved is the stability of the euro and the euro area. The question – how many countries can participate, this is the challenge with which Europe is confronted,’ Issing said… Politicians who blame German Chancellor Angela Merkel for creating turmoil in the markets by not taking further action on issues like Eurobonds should ‘shut up,’ Issing said. ‘They (politicians) always give the impression that they have the right medicine, which is more money, and markets will always ask for more. So this will be an endless game and politics will always be seen as prisoners of this process. It should be reversed. Politics should say what will not happen. This total mutualisation of debt – this is something which must not happen,’ Issing added.”

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