Rosenberg: "I Think The Dramatic Fiscal Tightening We Are Seeing In Ireland And Others Is Insane"
Rosie enters the "future of the euro" speculation race, and sees a "devastating deflationary shock" when Europe finally accepts the inevitable: "U.S. companies would likely confront a huge appreciation in the dollar, which would cut into their foreign-derived earnings base. Commodity prices would undoubtedly correct and safe-haven flows would certainly redress the loonie’s overvaluation gap. Treasuries would rally big-time." Stocks, of course, would plummet, and "Gold would remain bid — yesterday’s rally in the face of the USD rally is a case in point." On the other hand, the fact that we are starting to see traces of Krugman in Rosie's thinking is very. very worrisome.
SCENARIO BUILDING — KEY RISKS AHEAD
Yesterday’s very weak U.S. new home sales data underscore the mixed nature of the other data releases. That said, Q4 real GDP in the U.S. is now likely to come in a tad better than I expected. While the U.S. consumer seems to have some legs as year-end approaches, my worry list for 2011 has not changed. Next year, even assuming the Bush tax cuts are extended, fiscal policy at the federal level will withdraw five-tenths of a percentage point from real GDP, at the least. Furthermore, closing the massive budget gaps at the state and local level will withdraw a further 1.5 percentage points from GDP. Again, this is a conservative estimate but a total of two-percentage points of fiscal drainage with questionable offsets from the other sectors of the economy.
Then, of course, in Europe, there is fiscal tightening and rising risk premia associated with potential sovereign defaults. Those developments will have a negative impact on exports too. Also, the response to exchange rate manipulation in Asia could well draw higher tariffs, and the resulting trade war would impact asset prices and the economic outlook that much further.
I think the dramatic fiscal tightening we are seeing in Ireland and others is insane and I wonder how a new government in early 2011 is going to react. Spanish bond spreads are behaving like Ireland did precisely six-months ago when Greece was getting bailed out (it’s not really a bailout — the stringent strings attached are like a hangman’s rope).
Everybody seems to believe the euro is sacrosanct but this was also the view around the Argentina currency board nearly a decade ago, the country ultimately devalued in order to reflate its economy and pay off its debts in debased currency. After the 10-year currency convertibility plan was abandoned in early 2002, the Argentinean peso depreciated 80%, which in turn paved the way for massive trade surpluses, and from 2003 to 2007, real GDP expanded at a 9% annual rate, and real wages rose by nearly 5% per year. Growth ensued. Memories faded.
Sweden, in the early 90s, is another example, and the reason Iceland no longer makes the news is because the krona has been devalued 60%.
The end-game as I see it is that some of these peripheral EMU countries leave the union, go back to their own currency so they can reclaim control over their monetary policy and pay their debts in devalued punts, drachmas and pesetas. These peripheral EMU countries need to reflate but are being forced to do the exact opposite by being linked to a currency union. Other countries, such as Germany and the UK, that have big banks that own a ton of these peripheral European bonds will simply see their governments issue debt to cover the losses, either in part or whole (Merkel will see to it that in Germany’s case, it will be the former) in their financial sector. We’ll look back at this like we did Argentina and Russia ... with faded memories.
But if it plays out like this, it would be a devastating deflationary shock for the global economy, for at least a few months. And, U.S. companies would likely confront a huge appreciation in the dollar, which would cut into their foreign-derived earnings base. Commodity prices would undoubtedly correct and safe-haven flows would certainly redress the loonie’s overvaluation gap. Treasuries would rally big-time.
I'd welcome any responses/views to this thesis. Call it scenario building, but our pro-CAD and pro-commodity views are at stake. Gold would remain bid — yesterday’s rally in the face of the USD rally is a case in point.
And a broader catch up on key economic themes:
WHILE YOU WERE SLEEPING
Another mixed start to the day with most European bourses flashing red while Asia is mostly in the green column. Bond yields are backing up, especially in the European periphery. While there is talk now of boosting the European rescue fund, size doesn’t matter — these are loans, not gifts, and do not solve the problem of excessive debt burdens, exacerbated by fiscally-induced deflationary pressures.
Are these aid packages working? The short answer is no. The yield on a 10-year Greek bond has ratcheted all the way up to 11.93% — it was 8.96 % just prior to the IMF-EU rescue plan unveiled in early May. At these levels, how could Greece ever fund itself? Meanwhile, Irish 10-year bond yields are at their highest level since the EMU was created in 1999 (9.1%) and contagion risks are underscored by the fact that even Spanish bond yields have now risen in each of the past eight sessions. The U.S. dollar continues to firm up in this environment, ditto for the yen and gold, as investors take cover in the “safe havens”.
It was light on the foreign data docket but we did see some oomph in the U.K. retail sales data for November.
If anyone is keeping a scorecard on QE2, it’s not looking too good at the moment. No stimulus from the U.S. dollar, which is strengthening (thank you, Ireland). The equity market is consolidating, and Treasury yields have backed up sharply with the 10-year note seemingly poised to re-test the 3% threshold — when the specific objective was to reduce market interest rates. It may be time to go back to the drawing board. Indeed, have a look at this article in today’s NYT business section (Fed Considered Setting Target for Interest Rates on Some Bonds).