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Goldman's Tilton On European Clinical Contagion
- Borrowing Costs
- Capital Positions
- CDS
- Central Banks
- Credit Conditions
- Crude
- Daniel Tarullo
- European Central Bank
- Eurozone
- Goldman Sachs
- goldman sachs
- Greece
- Gross Domestic Product
- Initial Jobless Claims
- LIBOR
- Loan Officer Survey
- Meltdown
- Recession
- recovery
- Sovereign Debt
- Sovereign Risk
- Sovereign Risk
- Sovereigns
- Testimony
- Tim Geithner
A few days ago Tim Geithner said that any risk from Europe is isolated on the continent and there is no risk of it spreading to the US. Following a near 10% drop in the S&P we yet again have confirmation that the Treasury Secretary is a pathological liar or an idiot, or just so confused by analyzing the ever-increasing gobs of negatve data that his brain has officially switched off, we are not sure which, although either case would make him ineligible to practice the role of US Treasurer (unless to the list of permitted exemptions which currently only lists tax "avoidance", one adds lunacy). And while we await a clinical diagnosis on the SecTres' pathologies, we offer this analysis on how European contagion will come to the US from Goldman's Andrew Tilton, which, for what it's worth, is one of the better ones written on the topic.
- Markets have beaten a hasty retreat on fears that the crisis in the Eurozone periphery will exacerbate what already appears to be slowing growth elsewhere in the world. Eurozone stresses could affect US economic growth through three major channels: 1) the effect of a stronger dollar and weaker Eurozone domestic demand on US exports, 2) the impact of lower equity prices on US consumption and investment, and potentially 3) a renewed tightening in credit conditions.
- Our analysis suggests that most “contagion” effects are likely to occur via financial channels rather than exports. A “moderate” crisis—along the lines of the asset market moves seen thus far—would probably do limited damage to US growth, as the effects of weaker equities and exports should be partly offset by lower oil prices and lower long-term interest rates. The emergence of a broader credit shock in Europe would signify a transition to a severe crisis with more deleterious consequences for growth (see table above right).
- In a worst-case outcome (not shown), concerns about US government debt sustainability could tighten financial conditions further and force more rapid fiscal consolidation. But this does not seem imminent. Thus far, the opposite has been true, with ten-year Treasury yields rallying to our 3.25% target sooner than we expected.
- The year-on-year rate of consumer price inflation excluding food and energy fell to a 44-year low in April (see chart at right), consistent with our view that the large amount of slack in the economy should push core inflation close to zero by late 2011. High-frequency indicators have slowed a bit, with regional factory orders weakening in May, initial jobless claims rising in the latest week, and mortgage applications for purchase plummeting since the expiration of the homebuyer tax credit at the end of April.
Some participants expressed concern that a crisis in Greece or in some other peripheral European countries could have an adverse effect on U.S. financial markets, which could also slow the recovery in this country.
-Minutes of the Federal Open Market Committee meeting, April 27-28, 2010
Despite its origins in the domestic residential housing sector, the US credit crunch and recession ultimately caused severe damage to economies throughout the world, via trade and especially financial linkages. With increasing focus on the sustainability of sovereign debt in the Eurozone periphery, it is natural to wonder if “what goes around comes around.” The tremors in Europe have already been all too evident in US markets, but will they have a major impact on growth in the United States?
In this comment we review the potential channels for contagion from the Eurozone periphery to the US economy and assess the potential impact of each. This is not an assessment of the Eurozone periphery’s debt problems—for that, please see recent publications by our European economics team—but rather a “what-if” exercise assessing the effects of European stress on the United States.
Channels of Contagion
The heightened concern about the sustainability of sovereign debt in the Eurozone periphery has had a number of effects. It was evident most directly in a sharp rise in sovereign risk premia and borrowing costs. This threatened more aggressive fiscal tightening and potentially slower growth, hurting asset prices and sending the euro lower. Poorer growth prospects and worries about sovereign defaults have sparked concerns about European bank solvency, in turn raising questions about credit availability. Fiscal support from core European sovereigns and credit easing from the ECB have been rolled out in an attempt to contain the problems and calm markets.
We see four broad channels of (potential) transmission from Eurozone sovereign stress to the United States:
1. Weaker US export performance. The corollary of a weaker euro has been a stronger US dollar. That, along with the downside risk to European domestic demand if the crisis intensifies, points to weaker US export growth.
2. Lower equity prices. A weaker euro and heightened uncertainty about the European and US growth outlook have pulled equities down more than 10%. This discourages consumer and investment spending, at least on the margin.
3. Tighter credit conditions. As Fed Governor Daniel Tarullo noted in Congressional testimony yesterday, “One avenue through which financial turmoil in Europe might affect the US economy is by weakening the asset quality and capital positions of US financial institutions.” Concern about losses on debt of peripheral sovereigns has naturally raised concerns about the solvency of financial institutions that hold that debt. This has been reflected in slightly wider credit spreads and some stirrings of bank funding stress (though these remain small relative to levels seen in 2007-2009; see Exhibit 1). In theory, a full-blown European credit crunch could affect the US both directly (if funding problems extended to banks operating in the United States) and indirectly (if a credit crunch in Europe substantially weakened European growth).
4. Offsets from lower commodity prices and lower risk-free interest rates. Not all of the effects have been negative. A stronger dollar and the possibility of weaker European growth have already lowered commodity prices, most importantly oil: crude prices have fallen to about $70/barrel as of this writing, from an average of $80/barrel in the first four months of the year. Also, although short-term rates have hit the zero bound, long-term risk-free interest rates have fallen substantially.
How Virulent an Illness?
To provide a point of reference for the potential impact of Eurozone financial and economic stress, we consider two scenarios. The first “moderate stress” scenario is intended to reflect what we have seen thus far. It assumes a 10% decline in US equities, a $10/barrel decline in oil prices, and a 10% strengthening in the euro relative to the US dollar. We also assume a hit to Eurozone domestic demand of 0.5%; note this need not necessarily mean a meaningfully lower GDP growth outlook, since Eurozone exports would presumably benefit from the weaker currency. A “severe stress” scenario assumes price movements 2.5 times as large and a broader Eurozone credit crunch with a consequent 2% shock to Eurozone domestic demand.
For each scenario, we calculate the effects via the four “channels of contagion” listed above. As a cross-check, we do this in two ways: via an individual assessment of that channel’s effects on growth, and also via a vector autoregression (VAR) framework that evaluates all the effects simultaneously. In general, these approaches yield similar results, with our preferred specification shown in Exhibit 2.
1. Export effects look small. The euro area represents less than 15% of total US goods exports. Overall exports are a bit less than 12% of US GDP, so total exports to Europe account for less than 2% of US GDP. We found in previous work that a 1% slowdown in Eurozone domestic demand reduces US exports to the Eurozone by 1.35 percentage points, while a 1% appreciation in the euro/dollar exchange rate reduces US exports to Europe by about ¼ of a percentage point. These effects suggest a direct impact of only about five basis points on US GDP growth in the “moderate” scenario.
There are also indirect effects on US exports. Other US trading partners might grow more slowly because of the crisis, or US firms might lose share to cheaper euro-area exports. We can incorporate these effects by looking at the historical effect of dollar appreciation and foreign growth on overall US exports. A 1% appreciation in the trade-weighted dollar tends to push down US exports by about 0.6%, other things equal; this implies indirect effects comparable in magnitude to the direct effects. Still, the overall trade effect is likely to be quite small in the “moderate” scenario, about 0.1% of US GDP. In the “severe” scenario it would be three times as large.
2. More significant negative effects from the equity market selloff. The clearest impact comes via the equity market. With approximately $12 trillion of equity-related holdings, households suffer a wealth loss of $1.2 trillion in the “moderate” scenario. Assuming a fairly typical “wealth effect” of about 3%, the impact on consumer spending would be $36 billion in the moderate case and $90bn in the severe case; these represent 0.3% and 0.7% of GDP respectively. The overall effect is likely to be larger than this, since a decline in equity prices should crimp investment spending on the margin as well. The figures shown in Exhibit 2 reflect the results from our VAR analysis.
3. Credit availability a risk in a severe scenario. A defining feature of a more severe crisis would be a credit crunch in Europe that spills over into a pullback in US credit availability as well. Given the all-too-recent experience with international credit contagion, and the historical co-movement between US and European financial conditions (Exhibit 3), this is clearly something to watch for. At this point, we have seen only a modest increase in the cost of credit (about 20 basis points on investment-grade credit spreads). As discussed below, risk-free yields have moved significantly lower, pushing private-sector borrowing rates down on net. In the “severe” scenario, we assume this situation is reversed: wider spreads more than offset lower risk-free rates, resulting in a net drag on growth. This was what we observed in the acute stages of the 2008-2009 crisis.
However, should a European credit crunch occur, we think the transmission to the United States would be less intense than that experienced by European banks in the autumn of 2008. For one thing, central banks have developed a number of liquidity facilities and are better prepared to address any funding issues. For another, US banks’ gross exposure to Greek, Portugese, and Spanish debt (public and private) is roughly $90 billion, only a fraction of estimated European bank losses on US residential mortgage debt and related securities. More broadly, analysis of the co-movement of US and European financial conditions suggests that the transmission is typically stronger from the US to Europe than vice versa. Assuming a “typical” recessionary credit tightening (rather than a 2008-style meltdown) in Europe that is attenuated somewhat across the Atlantic, the median of our estimates for credit effects (both spreads and availability) in a “severe” scenario is around 1½ percentage point on US economic
growth, though obviously with great uncertainty around this result.
4. Lower oil prices are the most important offset. As the market reduces its assessment of world growth and the dollar appreciates, imported commodities cheapen, freeing up household income. The effects here can be significant: a $10/barrel decline in oil prices reduces household spending on energy by about $20 billion per year; if 70% of this were redirected to spending on other goods and services, the resulting $14 billion increase in real spending would boost real GDP by 0.1%, assuming that import leakage and “multiplier” effects on other spending roughly offset each other. VAR results suggest a somewhat bigger impact.
Under normal economic circumstances the Fed might provide additional support, but with rates at the “zero bound” and already expected to remain so for an “extended period,” options are limited. The bar for additional asset purchases looks fairly high, although this cannot be ruled out if growth slows sharply. However, longer-term risk-free interest rates have fallen by more than 50 basis points from levels prevailing earlier in 2010, in anticipation of slower growth and potentially an even longer period with the Fed on hold.
In a worst-case scenario (not shown in either scenario in the table), concerns about US debt sustainability could push up government borrowing rates, potentially forcing more rapid fiscal consolidation, and further impair the US growth outlook. For example, a 100bp increase in long-term Treasury yields would push up our US financial conditions index by 55bp; this in turn implies a hit of nearly a half-point to real GDP growth. As the crisis on the European periphery has shown, these reassessments can occur quickly and violently. However, the United States is unlikely to be “next in line” for any reassessment of debt sustainability. So far, US Treasury yields have actually dropped sharply—with ten-year Treasuries hitting our target of 3.25% earlier than we expected—and we believe the United States still has a window of opportunity to get its fiscal house in order before this becomes a major concern.
Monitoring the Patient’s Health
Market participants and policymakers can monitor these “channels of contagion” via a plethora of indicators. For trade, the US dollar exchange rate (either versus the euro or better yet, on a trade-weighted basis) should provide a good indication of the degree of headwind. Monthly data on exports to the Eurozone provide a more direct gauge, but are somewhat noisy, not adjusted for seasonality, and released with a substantial lag. We reviewed other leading indicators of exports in the May 17 US Daily.
Equity prices are straightforward, but assessing credit conditions is more difficult. Corporate credit spreads offer a real-time indicator, but one that covers only market-based lending and measures price rather than quantity. Detailed information on lending standards (such as the Fed’s Senior Loan Officer Survey) is released infrequently or with significant lags. We combine price and quantity measures in our proprietary “credit restraint index” (Exhibit 4). Signs of a more significant increase in funding strains, such as an increase in LIBOR relative to expected overnight rates, or a rise in bank CDS spreads, would also be a concern.
Our longstanding Goldman Sachs Financial Conditions Index captures many of these factors in one metric. Even more broadly, our global economics group has created a version of the FCI that folds in the estimated offset from oil prices on growth (Exhibit 5). The “oil-adjusted FCI” has tightened only slightly versus its April average, consistent with the small negative impact on overall growth that we show in the “moderate scenario” in Exhibit 2. The FCI includes corporate credit spreads but not a broader measure of lending standards, so these need to be monitored separately.
In conclusion, our exercise to map the channels of potential contagion from Eurozone to the United States finds that:
1. Most contagion is likely to occur via financial channels. The impact on GDP growth via exports is likely to be overshadowed by wealth and credit effects on spending. This finding is consistent with other recent research on international spillovers.
2. Events thus far should not be particularly damaging to US growth… Lower oil prices and lower long-term yields should provide a meaningful offset to the downturn in equities and thus far, there are no signs of a renewed credit squeeze. As noted above in Exhibit 2, we think the effects thus far should not be much more than ¼ percentage point on the economic growth outlook. That said, we emphasize that we have long expected a slowdown in US growth in the second half, and some recent indicators—too soon to have been affected by events in Europe—hint at deceleration. Whereas a month ago risks to our second-half growth forecast looked to be to the upside, uncertain spillovers from Europe constitute a meaningful offset to the downside.
3. …but a renewed squeeze in credit would point to a “severe” scenario. As discussed above—and experienced in dramatic terms in 2008—a credit shock can have a large and rapid effect on growth. Signs that one is emerging in Europe would point towards a US outcome that looks more like the “severe” case.
4. Watch the “oil adjusted” FCI and measures of credit availability such as our “credit restraint index.” Although there are many important indicators to keep track of, these two encompass the main channels of potential transmission from European distress to the US real economy and so provide a concise status check on contagion effects.
Andrew Tilton
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Hey someone delete this because it is simply not true Helicopter Ben and myself (Turbo Tim) have it under control. Even though this is 5 xs the size of Lehman go back under your rock....
Timmay couldn't smell shit on a dick, even if the dick was in his mouth.
By definition, if we have open swap lines to Europe there is already contagion.
ie: Geithner is lying.
me thinks you dont understand what a swap line is.
a swap line does not indicate contagion.
im not defending the opening of SL here, im just saying SL has only, at best, a temporary currency benefit and influencing market psychology.
Front Page Headline Huffington
(OBAMA) 'LACKADAISICAL AND NAÏVE' Carville Slams Obama Response To Oil Spill, Warns: BP Is 'Going To Take You Down!'soooooooooo, his own side is saying.......
our new young president, for political reasons only and entirely, has chosen to let evil big oil (who he has endlessly trashed at all opportunities) handle this crisis while he keeps his own sorry ass at a safe distance for the sole reason as not to be seen as owning the crisis.
hail to the chief!
harry truman he is not.
it's getting to the point where my skin actually crawls when i hear him speak about anything at all. (kind of the opposite of the conniptions chris matthew's leg goes through).
it's getting to the point where my skin actually crawls when i hear him speak about anything at all.
You are not alone bigdumbnugly.
About 15 percent of the country, actually. They're called Tea Baggers.
They're also called a lot of other things.
Most of it deserved.
duplicate
So, the US doesn't do jack-shit anymore except make Pixeldust and owes too much money and the time is coming sooner than we thought where that will be big trouble because Europe is visibly broke first.
We can just ignore that the areas that are driving the increased use/cost of oil are China and India.
Otherwise everything is just A-fucking-ok.
This is a typically myopic linear analysis that assumes everything else remains the same, no more Greece's, no more revelations of massive hidden debt, etceter. If you freeze everything else in place, Tilton might be right. But as we know, negative events occur in multiples. My assessment: garbage designed to sell Goldman product.
No. Not a pathological liar or an idiot. Both.
no problem in the euroooooooooooo. move along .
Capital ----> Step 1: Buy Dollars -----> Step 2: Buy Dollar Denominated Fixed Income Issues (Govt) -----> Step3: Buy Dollar Demoniated Equities.
==> Big rally coming in U.S. Equities.
Thanks, Europe!
Pharaoh Akhenaten changed beloved religious and cultural icons in ancient Egypt. He was so hated by the Egyptian people that after he died there were attempts to erase him from History. His monuments and statues were mostly destroyed, and for many years Archeologists had no idea what he even looked like. We still don't know how he died. Barack Obama, Nancy Pelosi, Harry Reed, Ben Bernanke, and Tim Geithner are going in the same direction. They will be reviled and cursed for decades to come.
I think you are right on.
++
but the real test is whether or not we can clean up the friggin pyramids they're building right now.
Agree on all of those names. You'll need to throw in:
W. Bush
Cheney
Rubin
Greenspan
Summers
Rahm
Rove
That was why some analyst said:
"You should vote the candidate you hate the most"
Because in the end of this economic cycle the nations rotten understructure will become evident and the president would be seen as the face and the hand behind of all that is corrupted in America.
Why voters choose Obama that much to put him in this predicament?
What happens in Europe stays in Europe. I seem to recall an anal-yst report several years ago about the first signs of Las Vegas real estate price deterioration headlined "What happens in Vegas stays in Vegas."
Bet against lyin' Timmy on this one.
Please gimmie an easy math question since I'm stoned!
why do you even post musings from any goldman employees? most are criminal sociopaths.
besides... we already know how this is going to end.
so what happens when everyone finally realizes banks are so tangled up in interest rate derivatives that raising them will blow them up?
Just watched Roubini on Bill Maher!!! makes them all look and sound stupid..:-)
I can't believe Maher still has a show.
one certainly has to applaud Mr. Geitner's steadfast disillusionment. It is not evident so much in his ongoing lies on behalf of the government and job he represents. Those are to be expected. It is in his fantastic belief that anything he has to say bears credence even as a government lie. He has fallen that far. His continued employment speaks volumes of the dis-ingenuousness of this astonishing regime... I thought we had seen it all with Greenspan, Rumsfeld and Cheney last time around....
Let's not remember that the Great Depression was largely due to the economic collapse of Europe following the stock market crash in the U.S.
i'm w you. let's not.
Sheithner.
For Europe :
Laughing as you sink :
http://www.abc.net.au/news/video/2010/05/20/2905304.htm
Very accurate and humorous description
These two guys are very funny.
They miss a point though. The weakness of the Euro is that unlike the FED, the ECB cannot emit credits that buy something like resources needed by societies to survive.
The US has value, everyone experiments it, as it keeps buying oil and other vital commodities.
In this situation, one does not need to grow concerned about a debt as emission of credits will keep the boat afloat.
The Europeans are trying to build a similar currency to the US. They are advancing on other fronts but I wonder how they are going to manage to give that property of value to their Euro.
Will be interesting to follow.
Ben & Timmy voices should be behind the prison walls (their screams - getting reamed) - not from where they are now.
Reminds me of "American banking system is solvent"
Another faulty brick in the economic wall.
The wall is beginning to look like this.
The March 2009 lows won't hold.
Updated DOW daily and weekly charts:
http://stockmarket618.wordpress.com
http://www.zerohedge.com/forum/latest-market-outlook-1
Couldn't agree more. The guy is a total liar, and if he's not, then by not knowing "the full extent of the backroom deals", he's incompetent.
Either way he's not fit for the job.
The face of the financial schemes going on is Turbo "jailbait" Timmay.
Does this analysis mean Goldman and J.P. Morgan are starting the next short covering leg upwards on low volume and SLP buy programs ? I read about some job improvements as this Bloomberg headline suggests : "Fed's Dudley Sees Beginning of `Significant' Job Growth". I don' t want to miss it...
How do they come up with an inflation number without including food prices and energy? Geithner and BB have lied before and all the way through this crisis.