A European Divorce and A Stressed Banking System
Babs and Clean Willie were in love they said
So in love the preacher's face turned red
Soon everybody knew the thing was dead
He shouts, she bites, they wrangle through the night
She go crazy
Got to make a getaway
Oh – no hesitation
No tears and no hearts breakin'
Oh – congratulations
This is your European divorce
(slightly adapted from ', a great song by the way, ed.)
A Divorce Is On Its Way
Mrs. Merkel and Mr. Sarkozy let it be known that the 'future of Greece is in the euro-zone' after talking with Greek prime minister Papandreou over the phone. Perhaps it is. A default does not necessarily mean that Greece must abandon the euro, although it may be seen as an 'easy way out' for Greece's politicians in order to regain the ability to devalue, and more importantly, have its own central bank finance the government. This would of course risk an eventual hyper-inflationary collapse, but one should never put anything past a desperate government.
Interestingly, the markets have taken to ignoring such affirmations of support. Greece's bond yields and CDS spreads have kept rising, with the latter reaching an incredible 5,702 basis points (see our chart section below).
It seems however that the markets are perhaps taking a less negative view of a Greek default otherwise. It is not knowable at this point how it would play out in terms of financial contagion, but it is known that the rest of the euro-area is preparing for the eventuality. Looking at Germany's internal debate, one can see the political will to support Greece waning by the day. Preparations to handle an eventual default are well underway. As the news magazine 'Der Spiegel' writes (this report is by the way well worth reading in its entirety):
“Even if the Greek government were to take this ultimate step, the consequences would be manageable, government experts believe. This was not the prevailing view in early May, however, when the finance ministers of the large euro-zone countries assembled in Luxembourg for a secret meeting with their Greek counterpart and Euro Group President Juncker. One of the items on the agenda was the possibility of Greece withdrawing from the monetary union.
While experts were still warning against the consequences of such a step in May, today those consequences seem more acceptable to the euro-rescuers. They have even found a solution for a problem that had Schäuble's officials worried at the time. Contrary to earlier assumptions, restrictions on the movement of capital, which could be used to prevent Greek citizens from moving their money abroad (something that would endanger the country's banks), are now seen as being compatible with EU law. Article 143 of the Treaty on the Functioning of the European Union offers a loophole, in that it permits certain countries to "take protective measures."
The new line is not entirely uncontroversial, however. This became apparent at a meeting of the euro zone's deputy finance ministers last Monday, when the so-called troika of the European Commission, European Central Bank and IMF gave its report on the situation in Greece.
The group was divided in the end. For the first time, there was a majority, led by the Germans, Dutch and Finns, that advocated pulling the ripcord on Greece. The southern countries, including France, were considerably more reserved. They feared that if funds were cut off for Greece, they could be next in line.”
We would note to this that any Greek saver who hasn't yet bought gold or transferred his money to Germany or some other safe destination should do so at the earliest opportunity after reading these words. It is obvious that it will be Greece's savers that will be sacrificed when the default comes. It is always the innocent bystanders, those who have prudently provided for the future, that get shafted in the end when corruption and fiscal mismanagement take their toll and the State faces an economic emergency. Argentina's citizens can vouch for this. Bank deposits in Greece of course continue to decline as can be seen in this chart.
It is noteworthy in this context that the Germans are thinking of continuing to support the Greek banks even in the event of a Greek default and Greece leaving the euro zone. Recall that when Argentina's default occurred, the government enacted a 'confiscatory deflation' that relieved the banks of a large portion of their deposit liabilities, while stiffing the country's citizens. As Joseph Salerno described the process at the time:
“Confiscatory deflation is a particular category of deflation. It is inflicted on the economy by the political authorities as a means of obstructing an ongoing bank credit deflation that threatens to liquidate an unsound financial system built on fractional reserve banking. Its essence is an abrogation of bank depositors' property titles to their cash stored in immediately redeemable checking and savings deposits.”
One of the major reasons why cutting off aid to Greece is now on the agenda is that there is a widespread belief that the financial contagion may actually be manageable. This notion stems from the fact that the economic performance and the ability to hew to fiscal targets has been markedly better in the other euro area countries that are at risk.
Via the 'Spiegel' magazine, how Greece compares to the other members of the 'PIIGS' stable. None are out of the woods yet, but Greece is in an especially difficult situation – click for higher resolution.
As we noted on Tuesday, shortly after the Greek government announced the introduction of additional taxes, its tax collectors actually went on strike. In fact they have been on a 'go-slow' strike for quite some time. According to the Spiegel report:
“Greek citizens and companies owe the state a total of almost €40 billion in taxes. The sum would more than cover the government's budget deficit for 2011.
But many government agencies are seen as inefficient and corrupt. Now that their salaries have been cut by 20 percent or more in the course of several rounds of austerity measures, the Greek tax authorities often perform the bare minimum of their duties, and sometimes even less. Some 17 tax offices did not perform a single audit in the first seven months of the year. In Corinth, a city near Athens, the local tax authority collected only €18,000 in value-added tax within six months, even though the region is home to one of Europe's largest casinos and a number of companies are headquartered there.
A plan to cut 150,000 public-sector jobs is making no progress, partly because civil servants constitute part of the base of the governing Socialist party.
We shouldn't be terribly surprised that many German lawmakers now believe this is actually a hopeless case. We have previously remarked on the growing rifts in Mrs. Merkel's governing coalition over the topic of support to Greece. It appears now that one way of getting the coalition backbenchers to vote in favor of enlarging the EFSF is to assure them that Greece will be let go if it fails to reach its fiscal targets by the time the next 'troika' review is scheduled.
Other noteworthy developments were that Mario Blejer, former governor of Argentina's central bank opined that 'Greece should default big' while China's premier Wen Jiabao let it be known that contrary to the impression that may have been created lately, China isn't in the business of providing support to bankrupt governments, which should get their 'house in order' first.
A Stressed Banking System – Gold Provides Relief
It is noteworthy that Tim Geithner ahead of his European visit is saying that he's convinced that 'no Lehman style collapse will be allowed' by the eurocracy. We would note to that: if the markets panic following a Greek default and a chain reaction of margin calls and growing fears over counterparty risk etc., is set off, then there is nothing the eurocrats can 'allow' or 'disallow'. Already stresses in the euro area banking system are very high. What we do however glean from his remarks is that contingency plans to support the financial system have been put in place.
Speaking of stresses in the euro area banking system, the ECB has provided $575 million in dollar funding to two European banks on Wednesday. The swap lines with the Fed remain open, and as we have pointed out for quite some time, dollar funding in the euro area is becoming a big problem for the banks. Note that the interest rate at which this funding is provided, while low in absolute terms, is still a stiff penalty rate compared to interbank funding rates (one month LIBOR stands at a mere 23 basis points, slightly below the upper target rail of the FF rate).
Moreover, the FT reports that euro area banks are now lending out their gold (or more likely, unallocated gold belonging to customers) at a steeply negative lease rate in their scramble to obtain dollar funding. Paying someone 48 basis points to borrow your gold is still a cheaper way of getting dollars than borrowing dollars from the ECB at a rate of 110 basis points. The beauty of it is, you don't even have to own the gold. As we pointed out when a large gold repo transaction was made with the BIS involving a few hundred tons of gold during the first major iteration of the euro-area debt crisis, customers holding gold in unallocated form must beware. The problem with this is that it kind of takes away the insurance function of gold – this is to say, the insurance it provides against a complete systemic collapse or even a milder form of crisis that leaves large parts of the banking system paralyzed and insolvent. In other words, unallocated gold holdings do not protect one against the so-called 'impossible' or 'unthinkable'. Since history is generously dotted with such allegedly 'impossible' events, one should perhaps give this matter some thought. Some people could end up finding out that when the time comes when they actually need their gold holdings most, they are no longer accessible to them.
As the FT writes:
European banks are rushing to use their gold to access much-needed dollar funding, in the latest sign of the growing liquidity crunch for the continent’s financial institutions.
Gold dealers and analysts said that there had been a strong move to lend gold in the market in exchange for dollars in the past week, accelerating in recent days.
The rush has pushed gold leasing rates – the implied interest rate for lending gold in the market in exchange for dollars – to record lows, according to Thomson Reuters data. The one-month gold leasing rate has plunged to a historic low of -0.48 per cent, suggesting that a bank lending gold for one month would have to pay to do so, at an annualised rate of 0.48 per cent. Traders cautioned that few, if any, banks were likely to receive those rates, however, saying that they had been skewed by a widespread reluctance among bullion banks to take gold for dollars.
Large bullion-dealing banks take gold on deposit from a range of customers such as investors, central banks and other commercial banks. Although they often lend out some of that gold around the end of quarterly reporting periods in order to reduce their liabilities, the latest move is unusually dramatic and highlights the stresses in the dollar funding market, according to bankers. The banks do not, however, lend all their gold and some of it is held in accounts that preclude them for using it for trading.”
The gold held in 'accounts that preclude them for using it for trading' is of course in allocated accounts. The implication is clear: unallocated gold is being used, as it is a mere promise to deliver an equivalent amount of gold on demand , but not necessarily the same gold that was deposited. It should also be clear that in the unlikely but by no means impossible event that customers holding unallocated gold demand a transfer of their gold to allocated gold accounts or demand physical delivery, there will be problems if their gold has been lent out.
If that doesn't happen, then the lending activity tends to pressure the gold price in the short term – pressure that will be reversed once the loans are called back. On the other hand, physical gold demand in Asia seems to be picking up strongly whenever gold dips below the $1,800 level. Also, if you consider Robert Blumen's article on reservation demand, it seems highly likely that current holders of bullion are probably reluctant to sell in view of the ongoing crisis. After all, the very type of event that gold is meant to insure them against seems to be playing out. So the borrowers of gold run a certain risk that by the time the loans are called back the price will be higher than at the time the lending transaction took place. Since the borrowers are reluctant (as evidenced by the negative lease rate), we suspect that arrangements to insure them against this eventuality are in place as well. Be that as it may, the near term effect of this lending activity on the gold price is likely negative.
Gold seems to have entered a consolidation/correction period. Note the MACD sell signal and the large volume spike at the retest of the recent high above $1,900. As we noted before, it is possible for overbought conditions to be worked off via 'time rather than price', but we wouldn't be terribly surprised if gold were to correct for a little while – click for higher resolution.
Stock Markets in Volatile Recovery Mode
European stock markets went through a volatile session on Wednesday, but ended the day considerably stronger. The markets kept being buffeted by the steady flow of often somewhat unsettling news, such as a report that Austria's parliament had refused to endorse the EFSF enlargement. This was later denied by finance minister Maria Fekter, who pointed out that the vote was merely postponed. Only an earlier plan to 'fast track' the EFSF vote was shelved.
“The Austrian parliament's finance committee Wednesday voted against a government motion to fast-track a budget proposal to fund the country's contribution to an enhanced European bailout facility.
The finance committee asked for more time for the details of the provision to be discussed. In notes from the meeting, some committee members said they wanted a more considered debate over the core issues facing European policy, denying the government the two-thirds majority it needed to add the vote on the increased funding to Wednesday's agenda. The move could delay Austria's approval of an improved European Financial Stability Facility until October, though it doesn't immediately threaten it being passed.
While a two-thirds majority is necessary to add items to the finance committee's agenda, the proposal for additional funding to the European Financial Stability Facility only requires a simple majority to be approved. The ruling coalition government holds 108 out of the 183 seats in parliament, guaranteeing a comfortable majority when the vote actually comes to pass.
Austrian Finance Ministry spokesman Harald Waiglein said the government was looking to set a date for the EFSF vote "as soon as possible; at the end of September or beginning of October at the latest." He added that today's finance committee meeting already had a fixed agenda before attempts to add the EFSF vote to it took place.”
We would note to this that the EFSF vote faces similar obstacles in most other European countries as they move to ratify the July agreements. In other words the 'time table problem' is alive and well, meaning that uncertainty will continue for some time yet. Nonetheless, stock markets are currently experiencing a rally from oversold conditions. It is definitely possible that the most recent move lower in European stock markets was indeed a 5th wave, which would argue for a corrective wave of 'A-B-C' or more complex form to be in the offing. As we have pointed out previously, the SPX positively diverged from European stock markets at their recent lows, which is also a hint that such a correction may be underway. However, as you will see in the charts below, this can not yet be stated with certainty.
The DJ EuroStoxx index continues its bounce, however it is too early to say if this is just a small reaction in an ongoing decline or the beginning of a more substantial correction of the decline. Note that the close was right at near term lateral resistance – click for higher resolution.
The German DAX Index offers a similar picture – a bounce into near term resistance – click for higher resolution.
As has been the case for some time, the US stock market has once again outperformed its European brethren, although a good chunk of the day's rally was given back during the final half hour of trading. This behavior is actually far less meaningful than is generally believed – the so-called 'smart money index' (SMI) that compares the market action during the first half hour of trading to that in the final half hour of trading has been a contrary indicator for quite some time. As opposed to the commonly held view that a rise in the cumulative SMI is a bullish omen and a decline a bearish omen, it is in fact exactly the other way around. In this sense the recent breakout from the SMI's downtrend that has pertained since the 2009 low must actually be regarded as a serious negative signal for the market's medium to long term outlook.
The SPX over the past two trading days – in the last half hour of trading on Wednesday, a good chunk of the day's gains was given back again – click for higher resolution.
The Barron's 'Smart Money Index' via sentimentrader.com. The fact that is has begun to rise is medium to long term bearish, not bullish as is generally assumed. The SMI has become a contrary indicator – click for higher resolution.
The S&P 500 daily – it looks a lot better than the European markets, and appears to be building a triangle. Unfortunately for the bulls, triangles tend to be continuation formations. Of course one can not rule out that a bigger bounce is in the works, but so far we have no evidence yet that the downtrend is in danger – click for higher resolution.
The near term outlook for stocks remains uncertain, but sentiment data such as put/call ratios and Rydex fund activity would certainly support a short term bounce as well. We would caution however that these indicators can often fail to 'work' for extended periods during major financial crises. Zerohedge notes that short positions at the NYSE have grown strongly of late and argues that this should support a short covering rally. Again, it often does, but there are notable historical exceptions to this 'rule'.
Euro Area Credit Market Charts
Below you find our usual collection of charts of CDS spreads, bond yields, euro basis swaps and a few other charts. Prices in basis points, both prices and price scales color-coded where applicable. CDS on Greek government debt continue to surge, but there have been slight pullbacks in other euro-area sovereign CDS. The Markit SovX has dipped slightly after its recent breakout, and our proprietary unweighted index of CDS on seven major euro-area banks has also recorded a slight dip on profit taking.
5 year CDS on Portugal, Italy, Greece and Spain – CDS on Greece at an astonishing 5,702 basis points now – click for higher resolution.
5 year CDS on Ireland, France, Belgium and Japan – a slight pullback – click for higher resolution.
5 year CDS on Bulgaria, Croatia, Hungary and Austria – click for higher resolution.
5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – click for higher resolution.
5 year CDS on Germany, the US and the Markit SovX index of CDS on 19 Western European sovereigns. The SovX has broken out from the bullish triangle formation as expected and is just pulling back a little – click for higher resolution.
10 year government bond yields of Ireland, Greece, Portugal and Spain – Greek yields once again at a new high – click for higher resolution.
10 year government bond yields of Italy and Austria, UK gilts and the Greek 2 year note. There was actually pullback of about 100 basis points in the Greek two year note yield – click for higher resolution.
Three month, one year and five year euro basis swaps – recovering a little from the recent cliff-diving exercise – click for higher resolution.
Our proprietary euro-land bank CDS Index (an unweighted average of 5 year CDS on the senior debt of BBVA, Deutsche Bank, SocGen, BNP Paribas, Intesa SanPaolo, Unicredito, and Monte dei Paaschi di Siena) pulls back a little bit as well – click for higher resolution.
5 year CDS on the 'Big Four' Australian banks – dipping in sympathy, as they always tend to do – click for higher resolution.
Charts by: Bloomberg, StockCharts.com, BigCharts.com, Sentimentrader.com
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