No Quick Fix Is In Sight
As we have pointed out yesterday , after the recent G-20 meeting a number of truly fantastic proclamations made the rounds. Imaginations were evidently running wild.
'G-20 Welcomes Progress on EU Debt Plan' the Wall Street Journal shouted out for example. What progress? What 'debt plan'? As we have noted – and this has since been echoed by other observers – there actually is no plan. There is not even a plan to make a plan, but something that is still one step further removed and terrifyingly vague. There are certainly plenty of ideas, but every one of them is in danger of being shot down by one or more of the 17 players comprising the euro area.
Now don't get us wrong – we hold that what many decry as Teutonic inflexibility is actually a good thing. The fact that the Northern half of the euro area 'core' is so strongly opposed to inflationism is a good thing as such. Alas, it also means that the markets won't get what they want, at least not when they want it (which is the day before yesterday, figuratively speaking). We must of course always suspect that the resistance to inflationism will eventually break down – there have after all already been a number of concessions, such as the ECB's recently announced 'QE Lite'.
Moreover, the resistance to inflationist ideas does not mean that what the Northern tightwads have in mind is a 'good plan'. As Dr. Jim Walker of Asianomics never tires to point out to us, one of the core problems – namely the lack of competitiveness of the euro area's periphery – remains completely unaddressed. There is simply no credible proposal in sight regarding the revival of flagging economic growth. Such a proposal would entail far more than just 'austerity' imposed by reluctant lenders. It would entail bold pro-free market reforms – a striking down of many of the regulations and obstacles to wealth generation that the EU's bureaucrats love to create in such bewildering abundance.
One of the more funny headlines yesterday was surely ''. This sounded as though the rest of the G-20 had issued an ultimatum to the eurocrats that everyone now expects to lead to a bold rescue operation. The October 23 meeting of EU heads of state supposedly is when the EU is expected to 'deliver' on the emergency plan.
As analysts at Daiwa remarked, the market's hopes for a 'bazooka' are entirely misguided. In they point out that given that the idea of giving the EFSF a banking license to enable it to borrow from the ECB is off the table, the alternative – an 'insurance scheme' that will transform the agency into something even more akin to a CDO is far too weak and self-referential to be regarded as a 'bazooka' by the markets. The 'money quote' from Blattner's commentary is this:
“But this insurance scheme is flawed and is unlikely to pass the test of market scrutiny. First, there is a dangerous degree of randomness embedded in such a scheme. The decision to guarantee the losses of some government bonds and not of others risks generating a two-tier European bond market. Markets would begin to wonder whether an Italian bond with a 20% loss insurance is a better investment than an unsecured French or Belgian bond. Will Belgian (and potentially French) bonds also therefore need protection, watering down further the EFSF’s resources? And which criteria determine the haircut protection on offer?
More fundamentally, however, the plan assumes that the full €780bn of EFSF guarantees can be used. But even ignoring the €130bn of resources already committed to Greece, Portugal and Ireland (which is the equivalent to €230bn in guarantees) and the potential calls on the EFSF for bank recapitalisations, around a third of this (€235bn) are guarantees from Italy and Spain themselves.
Frankly, what use is a guarantee that is partially guaranteed by the country that already (supposedly) guarantees the bond in the first place, particularly in view that the EFSF has no paid-in capital? So, with only around €320bn in guarantees left, the money would be just enough to cover 10% of potential losses of Italian bonds, 15% of Spanish, and 20% of Portuguese and Irish bonds (we see little point in providing a guarantee on Greek bonds at the current juncture).
Will a 10% guarantee on Italian bonds do the trick? It might. But we are sceptical. Markets will have the final word.”
Regarding the idea that the euro-area has 'one week' to make good on implementing a TARP-like plan to rescue both its sovereigns and tottering banks, Germany's political leaders let exactly one day pass after the G-20 confab before pouring a good measure of cold water on this particular fantasy. As Bloomberg reports, 'Germany Shoots Down ‘Dreams’ of Swift Fix'.
As soon as this headline hit the wires, stock markets in Europe reversed from a large initial gain and went negative. In US trading, the stock market picked up where the euro-area's markets had left off and went from 'weak' to 'very weak' after a disappointingly negative reading on the Empire State manufacturing survey was released, which added to the shift in sentiment. The New York Fed's regional survey's details can be (pdf). It makes for grim reading.
“Germany said European Union leaders won’t provide the complete fix to the euro-area debt crisis that global policy makers are pushing for at an Oct. 23 summit.
German Chancellor Angela Merkel has made it clear that “dreams that are taking hold again now that with this package everything will be solved and everything will be over on Monday won’t be able to be fulfilled,” Steffen Seibert, Merkel’s chief spokesman, said at a briefing in Berlin today. The search for an end to the crisis “surely extends well into next year.”
Group of 20 finance ministers and central bankers concluded weekend talks in Paris endorsing parts of Europe’s emerging plan to avoid a Greek default, bolster banks and curb contagion. Providing a week to act, they set the Oct. 23 meeting of European leaders in Brussels as the deadline.
On the summit agenda is how any recapitalization of Europe’s banks “might be carried out in a coordinated way” and how to make the European Financial Stability Facility, the EU’s rescue fund for indebted states, as effective as possible, Seibert said. The leaders will also discuss aid for and ways to tighten economic and financial policy, he said.
The euro retreated as much as 1 percent to $1.3739 from a one-month high against the dollar after Seibert’s comments. The currency last week had its biggest gain in more than two years on speculation that policy makers were moving closer to stemming the crisis. German 10-year bonds rallied and the Stoxx Europe 600 Index reversed an advance of as much as 1.5 percent and was down 1.4 percent at 4.45 p.m. in Frankfurt.”
Seibert’s statement “moved the disappointment trade to this morning,” Carl Weinberg, founder and chief economist at High Frequency Economics, said today on Bloomberg Television. “We’re looking at a really big disappointment if we don’t get a funded, operational and agile response to the bank recapitalization problem as soon as possible.”
It's going to take until the end of the year? Promise? The markets won't wait around to see what might happen until the end of the year. Mrs. Merkel is entirely correct to focus on a long term solution – even though the real problem bedeviling the euro has so far not even been mentioned once by any of the politicians and bureaucrats involved in the 'rescue operation'.
The real problem is of course that during boom times, the fractionally reserved banking system will massively expand loans and deposits and the distribution of this expansion will always be uneven across the disparate economies of the euro area. Malinvestments will thus be found not to be evenly distributed either when the boom turns to bust. Some nations will therefore be hit harder than others when the liquidation stage begins – which is precisely what has happened. Remember here that it mattered little whether a country adhered to the Maastricht criteria while the boom was still going strong: Ireland for instance went from being a euro area model pupil to bankruptcy within less than two years of the beginning of the bust. The only way to counter this is a type of reform that will invariably clash with the existence of the welfare state. Sound money and fully reserved banks would mean that the size of governments must vastly shrink – the State's continuous expansion would have to be rolled back. This type of reform simply is not going to happen, at least not voluntarily.
Still, Mrs. Merkel is correct insofar as she is trying to focus on a longer term solution to the euro area's problems, notwithstanding the fact that the ideas presented so far are missing the mark.
Alas, she is once again overestimating the patience of the financial markets. The markets are trying to force the issue – they demand a 'bazooka'. If they don't get one, it will mean that stock markets around the world will plunge, government bond yields and CDS spreads will continue to blow out, and interbank lending will freeze up further.
The latter two points will make it ever more difficult to come up with a solution that actually preserves the euro-area's integrity. One only has to ponder a single question in this context: if Italy's and Spain's bond yields should pass the 'point of no return', how could the EFSF construct, or indeed anyone, stop a collapse of the euro area from unfolding? It would be impossible.
France's Credit Rating In Danger
In addition to the complications that are already well known, an additional problem is now rearing its head – and it is a problem for which there will be no solution if it should become 'viral'.
As an aside here, not all of the complications are getting the attention they deserve – for instance the vast deterioration in Portugal's situation has so far not really gotten much press – but this is something that as we have pointed out for some time is likely going to change soon. Portugal is simply another version of Greece – it is facing the same quandary.
The problem we want to focus on here is however the danger posed by a possible downgrade of France's current 'AAA' credit rating. This rating is absolutely essential to support the EFSF. And yet, if France should now give large additional guarantees to the EFSF, the mere fact of issuing said guarantees could be sufficient grounds for the credit rating agencies to downgrade France's rating – which in turn would then make the guarantees worth much less. In fact, it is very much conceivable that following a downgrade of France, the EFSF itself could also lose its current AAA rating – and this would deal a devastating blow to the entire bailout project.
As it were, S&P has already warned several weeks ago that an enlargement of the EFSF would likely 'lead to rating action'. France's public debt to GDP ratio is nearly at 86%, so it is clear that the country would be in the crosshairs of the rating agencies. The big surge in CDS spreads on France over recent months and the recent large jump in yields on the French government's bonds represent a big warning sign, as quite often the rating agencies will simply validate the market's assessment with a lag.
As the German news magazine 'Der Spiegel' reports:
“Ever since Europe's common currency crisis began erupting in earnest last year, two countries have been largely responsible for preventing a complete collapse of the euro zone: France and Germany. Without their support, Greece, Portugal and Ireland would have long since declared insolvency.
This year, though, with the euro crisis going from bad to worse, it is looking increasingly likely that France may not be able to emerge unscathed. Indeed, leading German economists on Monday told the website of financial daily Handelsblatt that French debt is likely to be downgraded in the months to come.
"A new bailout package for debt-stricken countries in the southern part of the currency union will also strain French state finances," Jörg Krämer, chief economist for the German banking giant Commerzbank, told the website. "In the coming year, the country could lose its top AAA rating."
Thorsten Polleit, chief economist of Barclays Capital Deutschland, agrees. "The problems of their domestic banks could result in significant additional pressure for the financial situation of the French state," he told the Handelsblatt website.
Budget Problems of its Own
With French banks holding significant quantities of Greek debt on their books, however, an already heavily indebted Paris would likely have to plunge even further into the red to recapitalize its banks. Highlighting the problem, the ratings agency Fitch placed several French financial institutions on its watch list last week while Standard & Poor's downgraded BNP Paribas on Friday.
Furthermore, France has been battling budget deficit problems of its own in recent years. Just a few weeks ago, Paris announced an austerity program aimed at bringing its deficit, which is projected to be 5.7 percent of gross domestic product this year, to below the EU-mandated ceiling of 3 percent by 2013. Its overall debt stands at 85.5 percent of annual GDP, well above the EU limit of 60 percent. Any additional expenditures relating to bank bailouts — or even additional euro-zone bailouts — would slow the country's return to fiscal health. The current state of French finances, Polleit told Handelsblatt, is anything but reassuring.
"A further expansion of the EFSF … would very likely mean an end to France's AAA rating," Ansgar Belke, research director for international macroeconomics at the German Institute for Economic Research, told Handelsblatt. "But any leveraging of the EFSF, which would increase the likelihood of a loss of guarantees, would be poison for France's rating."
The concerns over France's credit rating are now spreading very fast – this could easily become yet another self-fulfilling prophecy. As Bloomberg reports today:
“The French 10-year bond yield climbed to 100 basis points above its German equivalent for the first time since the euro’s 1999 debut after Moody’s Investors Service said the nation’s AAA credit rating is under pressure.
French securities trailed gains in other top-rated debt after a report showed China’s economy grew at the slowest pace since 2009, fueling speculation the global economic recovery is sputtering. France’s financial strength has weakened because of the financial crisis, New York-based Moody’s said yesterday. The euro-area’s second-largest economy, is a guarantor of the European Financial Stability Facility regional bailout fund.
“If the EFSF is expanded, it would increase the contingent liabilities for AAA guarantor states like France and Germany, which would be good for the periphery but not necessarily that good for stronger euro countries,” said Elwin de Groot, senior market economist at Rabobank Nederland in Utrecht, Netherlands. “You can see the market’s concern in the spreads.”
As far as we are aware, France is very worried about potentially losing its vaunted AAA rating. This means that it has every reason not to agree to a 'bazooka' that vastly increases its potential liabilities.
What does that leave us with? There is only one method that the markets would regard as a 'bazooka' and that at the same time would leave the credit ratings of the EU's 'core' intact: money printing by the ECB. If the EFSF were to be issued a banking license, the ECB could begin to fund it and help it leverage its collateral with money from thin air.
However, the ECB itself, as well as Germany, are strictly against pursuing this course. We do not see any way around these obstacles that could possibly satisfy the markets in the short term. Therefore the danger of a global stock market crash is once again vastly increasing.
The Stock Market
Our reader Bernard from Quebec who is specialized in wave counts has taken the time to update our 'SPX crash chart' that we first presented back in late August, when we asked 'Could the Unthinkable Happen?'.
The updated chart considers the more complex corrective wave that has formed since then and brings it into the context of the possible wave count that regards the recent upward correction as only wave 2 of a large impulse sequence. Please be aware that this remains a very low probability outcome, but the probability is definitely higher than it would be without the euro area crisis backdrop.
Here is Bernard's updated chart (as this was mailed to us last week, it does not yet include Monday's decline, but it has certainly anticipated it):
A possible – and very bearish – wave count for the S&P 500 Index – click for higher resolution.
It is in our opinion important to not rule out any outcomes, as remote as they may appear. As we noted yesterday, the short term sentiment indicators would actually support a continuation of the recent rally – but our long term indicators remain very bearish, and given the crisis in Europe one can not rely on overly bearish short term sentiment to save the day. So keep in mind that what is depicted above can unfortunately not be dismissed out of hand.
Today, the German business confidence index was published, further confirming that an economic contraction is well underway in the euro area.
“The ZEW Indicator of Economic Sentiment for Germany has decreased by 5.0 points in October 2011. This is the eighth decline in a row. The indicator now stands at minus 48.3 points. This value is below the indicator’s historical average of 25.3 points. A lower value of the indicator was seen last in November 2008.
Weak data concerning Germany’s domestic economic activity have contributed to the indicator’s decline. Due to the decrease of retail sales and industrial new orders the financial market experts may see their fears come true that the current government debt crisis might cause German companies and consumers to postpone investments and consumption spending.
In October the assessment of the current economic situation in Germany has lost ground for the third consecutive time. The corresponding indicator has dropped by 5.2 points to the 38.4 points-mark. Economic expectations for the eurozone have decreased by 6.6 points in October. The respective indicator now stands at minus 51.2 points. The indicator for the current economic situation in the eurozone has dropped by 3.8 points and now stands at the minus 31.7 threshold.”
A chart of the ZEW indicator of German economic sentiment.
Meanwhile, Greece had to admit that its deficit was even bigger than originally calculated. Greek bond yields have continued to blow out in the wake of this revision.
The yield on Greece's one year government note reaches a new record high of nearly 170% – click for higher resolution.
We will post an update our usual list of charts on euro area CDS, bond yields and euro basis swaps tomorrow.
Charts by:StockCharts.com, Bloomberg
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