Let’s return this week to the broader global Macro Credit Thesis. First of all, we live in a highly over-indebted world that becomes only more so each year. Moreover, the global system is today in an exceptionally high-risk phase of rapid non-productive debt growth in concert with historic financial and economic imbalances. Global policymakers are desperate to reflate debt and economic structures, in what I believe is both ill-advised and inevitably destined for failure. And there is the issue of history’s greatest financial mania…
The Greek debt crisis was the first crack in the global government debt Bubble. For the past two years, I’ve drawn various parallels between Greece and the subprime eruption here in the U.S. In both cases, the marginal borrower in respective Bubbles lost access to cheap market-based finance. The sovereign debt crisis in Europe set in motion dynamics that would see the crisis methodically gravitate from the “periphery” to the “core,” while U.S. mortgage finance saw the surge in subprime defaults migrate to a broader base of “prime” borrowers. And, of course, along the way there were aggressive policy responses. I have argued that, at the end of the day, the policy responses in ’07 and ‘08 contributed to the seriousness of the late-2008 financial and economic dislocation.
Taking a step back, I guess we shouldn’t be too surprised by the prolonged nature of the unfolding European/global crisis. After living though the severity of a chaotic 2008, global policymakers have been determined to react more quickly and forcefully. Especially in Europe, this has bought time and ensured that respective boom and bust dynamics drag on.
Three years ago, Greece could borrow for two years at about 2.0%. The marketplace recognized that Greece had buried itself in debt, although players were as well confident that Europe would never allow a Greek default. By May of 2010, Greek two-year yields surpassed 18% and the nation was hopelessly insolvent. Two and one-half years later, Greece (population – 11 million) has burned through two bailouts – and more than $200bn – and is today trapped in depression and desperate for additional bailout support. It seems inevitable that Greece will exit the euro. Yet, and especially after the European crisis began spiraling out of control this summer, the marketplace is confident that European officials remain determined to postpone all days of reckoning.
When the subprime crisis erupted in the spring of 2007, it marked an end to an era. The ultra-easy mortgage Credit that had fueled a buying, building, spending and price Bubble throughout housing and the broader U.S. economy was coming to a conclusion – although, somehow, very few appreciated this at the time. Still, the hedge funds and others did recognize that they had to reduce exposures to high-risk “private-label” mortgage-backed securities (MBS). And after the flow of finance into the riskiest mortgage-related securities and derivatives reversed, some speculators even moved to take short positions.
The resulting dramatic tightening of financial conditions at the “periphery” (i.e. subprime) then began to wear away at confidence in somewhat less risky mortgages (i.e. “Alt-A”). And as the marginal homebuyer lost access to mortgage Credit, inflated home prices reversed and headed lower. Declining home prices then began to weigh on confidence in mortgage finance more generally, which led to a further tightening of mortgage Credit. This added pressure on leveraged holders of mortgage instruments, while further pressuring real estate values and market confidence. And as the nation’s housing markets began to buckle, the marketplace increasingly feared the financial and economic consequence of a major downturn. In the fourth quarter of 2008, a crisis of confidence finally erupted at the “core” due to unmanageable problem debt and related system leverage. Faith that policymakers could keep things under control was shattered. Europe has been on a similar track.
Importantly, stimulus measures by the Federal Reserve failed to stem the debt crisis – failed to stop the crisis of confidence from gravitating from the “periphery” to the “core.” The Bubble was creating an ever increasing amount of suspect Credit, problem loans and related excess that would surface come the inevitable bursting. Indeed, I would argue that by prolonging the mortgage finance Bubble (in terms of lending, leveraged speculation and economic maladjustment) Federal Reserve policymaking ensured a more problematic scenario. The system would have been more resilient had the markets begun discounting the significantly changed post-Bubble backdrop in the initial months of 2007 (better yet, much earlier). Instead, increasingly speculative markets became fixated on predictable policy responses. Stock and global risk market prices fatefully diverged from fundamental (post-Bubble) prospects. The S&P500 traded to a record 1,575 in October of 2007 – heading right into the worst crisis in decades.
I am convinced – actually, at this point, it seems rather obvious - that global policymakers have made a very problematic situation worse. The global system would be less vulnerable today had speculative markets not again fixated on aggressive policy measures. I argued at the time that the ECB’s Long-Term Refinancing Operations (LTRO) only exacerbated European fragilities. In particular, the $1.3 TN of central bank liquidity ensured that Spanish, Italian and other European banks increased their exposure to suspect sovereign debt. It was a policy roll of the dice. The LTROs did incite big rallies in European debt and equities, along with global risk markets more generally. Not unpredictably, within months Europe was succumbing to an even deeper crisis. Global markets and economies were hanging in the balance.
In desperation, ECB president Draghi fashioned his “big bazooka:” Outright Monetary Transactions (OMT) – the promise of open-ended support for Spain and other troubled issuers. Importantly, Mr. Draghi made an extraordinary warning to those that had positioned bearishly against Europe. And while the jury is very much out on whether Draghi has much of a bazooka, this somewhat misses the point. The Draghi Plan incited a major short-covering rally in Spain, Italy and periphery bonds, in European equities, and global risk markets more generally. Indeed, the Draghi Plan forced the sophisticated speculators to cover their European shorts and even go leveraged long. Instead of a roll of the dice, it was betting the ranch.
The consensus view has Europe now moving beyond the worst of its crisis. Debt auctions have been going smoothly. Spain and Italy in particular have issued huge amounts of debt, now having satisfied much of their 2012 borrowing requirements. At least on the surface, the situation appears to have significantly stabilized over the past few months. Unfortunately, I believe this optimism has highly fragile underpinnings.
Many believed that the worst of the mortgage crisis had passed by April 2008. The Fed had orchestrated JP Morgan’s takeover of failing Bear Stearns. Clearly, most believed at the time, the Fed was sufficiently on the case and would not allow a further crisis escalation. The reality, however, was that altered financial and economic backdrops were quickly moving beyond the Fed’s control.
These days, the European economic backdrop seems to deteriorate by the week. Importantly, the Draghi Plan and bullish market reactions have not translated to the real economy. Indeed, the bursting Bubble “periphery to core” dynamic has actually gained momentum. I posited earlier in the year that there were broad ramifications for the crisis having afflicted “core” country Spain. The Spanish economy is significant, and its economic depression is now increasingly reverberating throughout the region. Importantly, fellow “core” economies in Italy, France and Germany are today showing ill-effects.
The Italian economy is weak and the German juggernaut is weakening. Yet I am most closely watching happenings in France. France’s October manufacturing PMI index was reported at a weak 43.5, confirming that September’s 3.3 point decline was no fluke. ECB monthly lending data released earlier in the week offered no encouragement. Lending to French corporations showed another marked decline, from 1.5% annualized to only 0.6% for the month. Lending was still at a 3% annualized rate back in April. Lending to households declined to 2.7% annualized in September (down from 4.2% back in May).
I have expected heightened attention directed at France’s deteriorating economic fundamentals, along with closer scrutiny of French financial institutions. Thursday, Standard & Poor’s downgraded many of France’s major banks, including its largest lender (financial conglomerate), BNP Paribas. From Bloomberg: “France’s 13-year-high unemployment rate, government debt approaching 90% of gross domestic product and trade deficits ‘are being aggravated in our view by the on-going euro-zone crisis, a more protracted recession across Europe, and lower domestic-growth prospects,’ S&P said. French banks also face ‘potentially limited, but still noteworthy, impact from an ongoing correction in the housing market,’ it said.”
The bloated French banks are heavily exposed to myriad risks (regional sovereigns, corporate, mortgage, capital markets, emerging markets, etc). I’ll also be rather surprised if, before all is said and done, the housing correction has only a “limited impact.” Indeed, the aggressive European policy responses over recent years have inflated home prices in France, Germany and throughout the northern nations perceived by the marketplace as safe havens from the crisis at the periphery. It’s a similar dynamic to when Fed policy responses to “periphery” mortgage problems actually lowered yields and extended the life of the “core” agency MBS Bubble. In Europe, safe haven inflows have worked to extend “core” country booms. But with these “core” economies now succumbing, there will be only deeper concern for the soundness of Europe’s major financial institutions.
The Draghi Plan is risky business. The speculator community was enticed back into European debt and equities markets, and in the process the euro. But how stable is this finance? Are the speculators true believers or policy opportunists? Investors in Spanish and Italian debt were willing to buy, knowing that these high-yielding markets were backstopped by the Draghi ECB. These markets became a magnet for trading-oriented fund managers looking for immediate performance. And as markets rallied, the perception took hold that the worst of the crisis had passed. Global speculators and investors jumped on the bandwagon, believing that more normalized financial conditions would spur a self-reinforcing economic recovery. In a world of intense investment performance pressure, performance-chasing and trend-following trading strategies ensured large technically driven flows into the region.
It’s going to be an interesting couple months. There’s an election approaching that could have major market ramifications. Perhaps “fiscal cliff” worries can be pushed out to 2013. But this hedge fund, performance-chasing and trend-following market dynamic really has me intrigued. This week again seemed to provide evidence that at least some traders have one eye fixed on the exits. Spain 10-year yields were up 22 bps and Italian 10-year yields rose 13 bps. Portuguese yields surged 47 bps. Spain Credit default swap prices surged 31 bps. The French to German 10-year bond spread widened 10 bps. European stocks were hit, with the German DAX and French CAC 40 both down 2.0%. It is also worth noting the weakness in commodities prices. This week saw notable declines in industrial-related commodities, including tin, nickel, lead, zinc, copper, palladium, and platinum – not to mention the slide in energy prices.
There are literally thousands of hedge funds these days fighting for survival. They cannot afford to miss a rally. But they also can’t tolerate significant losses. Everything is on a short leash. There are also thousands of mutual fund managers and other investors that will buy on strength or sell on weakness. It has become a highly speculative and unsettled backdrop. Meanwhile, markets have traded north as fundamentals have headed south.
It all becomes even more interesting when one ponders the credibility of Draghi’s OMT. How big, really, is that bazooka of his? How much firepower does the ECB actually have when the Bundesbank is opposed to the whole thing? Is it even legal? And how big does it have to be if the markets start to fret about France? Would the OMT lose credibility if the marketplace begins to fear a significant economic downturn and bank problems in France and Germany? Or does the market stick with the view that the more dire the situation the more Draghi and European politicians can be counted on to “do whatever it takes.” They can hold it together through year-end, can’t they?
Well, it’s shaping up to be quite a confidence game. But it’s those weak-handed hedge funds. Do they hold tight - or do some decide it might be best to be first in line before the crowd rushes for the exits?
