The markets are rarely satisfied, wanting more monetary easing to help the liquidity “problem” that no longer exists or alternately wishing the Fed to tighten, if only to drain out the liquidity that has been poured over the financial markets since 2008. The global financial markets are beginning to paint themselves in a corner, expecting much more than politicians or central banks are ready or able to provide – at least right now. The not so little known secret is that everyone in power wishes to stay there, whether a central banker or politician (or CEO for that matter). It is when the unstoppable force meets the immovable object that things begin to get interesting. Those two forces are playing out in Europe and we all have a front row seat to the festivities.
The unstoppable force is and has been debt. Whether on consumer’s balance sheet, the central bank, the large country banks or even government – debt and paying those debts is at the core of the global problem. How that is being dealt with by the various entities is instructive in how things may turn out somewhere down the road. First up are the domestic large banks, originally the direct benefactors of government handouts (TARP) that for some have been paid back. Banks historically have made money on the spread or the difference between what is paid on deposits coming in the front door and loans going out the back door. While not a perfect relationship, a reasonable guide is the difference between short and long-term treasuries.
The question may be asked if Operation Twist has been effective in pushing down long-term rates and judging by the above, the answer is that spreads between short and long-term rates have indeed narrowed dramatically in the past year. As interest rates across the curve begin to flatten out, the spread available to banks also begins to narrow. This has given rise to the “new” model used by JPMorgan in “hedging” their portfolio and trading for their own account, something that banks 15+ years ago never used to do. However, in today’s environment of low economic growth (low loan growth) and poor spreads, banks are left to other, currently legal, means to generate profits. It also makes that profit stream much more volatile than the mundane days of collecting 3% spread and on the golf course by 3pm.
An interesting and more twisted course has been taken by the large European banks that have historically been tied to the governments. Here the governments have been providing the liquidity to the banks so the banks in turn can buy government debt so the governments have the liquidity to provide the banks. While very simplistic, at the core this is what has been the European model to the liquidity crisis. Unlike the US, where (in theory) banks and government are separate; in Europe they are more intertwined. Complicating matters, at least since the development of the Euro currency, is the lack of any one government to print their way out, as can happen in the US. The lack of a central common government for the European Union is putting pressure on each country to adhere to the common union, but also be mindful of their citizenry. Hence the powerful and awkward position Germany finds itself today – major provider of funds to other countries forcing the German citizens to pay for problems not of their own doing.
The finger pointing at the G-20 and around the world as of late is an outgrowth of the two very different situations. Germany is looking to the US, hardly a paramour of conservative fiscal policy, with a jaundice eye when the US asks Germany to just pony up the additional funds for bailouts. Those bailouts, seemingly the norm in the US cannot be done on the scale required due to the rules governing the Euro, voting among members and an unequal footing among the members. At least in the US, for good or ill, there is only one place to center blame for profligate spending and how that spending is being funded. So lack of a political unity across the Eurozone makes it difficult to enforce any fiscal policy to all members.
The key point here is that liquidity has been pumped into the financial system around the world, with little economic impact to show for all the efforts. Solvency of the global banking/government institutions remains a primary concern, as questions remain about the level of assets to extinguish the debt being held. The debt overhang on the economies of the world is acting as a wet blanket to economic growth. Until debt can be properly handled, either by writing/paying it off, expect that global growth will remain substandard.