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Is The Sovereign Credit Crisis A Function Of Imminent Liquidity Tightening?

Tyler Durden's picture




 

Many have wondered just what it was about the past month that has woken up the bond vigilantes from their euro zone slumber, prompting them to suddenly and aggressively punish deficit transgressors. After all, it is not like the massive deficits appeared overnight. Surely had the sovereign bond and CDS widening been more gradual the European authorities would have had no recourse to blame cash and CDS "speculators", whose actions have merely forced the market fundamentals to catch up with reality. Yet due to the sudden move, chaos is rampant, and any minute now 6 scapegoats are expected to be named, in an attempt to deflect anger away from fiscal blunders by various administration officials, whose incompetence is the primary cause for the PIIGS crisis. Morgan Stanley's explanation for the sudden and dramatic move has to do not so much with endogenous fiscal constraints, but more with the ever more prevalent opinion that the giant liquidity pump is coming to an end. Is the market merely pricing in the removal of liquidity and striking at those who will be impacted first when the tide finally starts to recede?

For a long time, we have stated that rate levels are unnaturally low and are a product of QE and other government support facilities. These liquidity and support facilities were ultimately responsible for the record-breaking inflows into bond funds from money market funds and has kept rates unnaturally low. But ultimately the sovereign credit markets will act to right this ship. As we are seeing in Europe, the plans for liquidity withdrawal are causing a differentiation in credit spreads as measured by sovereign CDS spreads (Exhibit 4). This is resulting in a rise in yields in many of the European peripherals. In a strange but predictable way, the market is seeking a center of gravity for relative valuations; simply put, this is an exercise in market efficiency.

Not surprisingly, the proposed resolution for Europe's fiscal problems would hinge, as always, on how Central Bankers are responding to the prevailing supply/demand climate in the region. Is Europe entering an inflationary or deflationary period? Morgan Stanley, following traditional economic precepts, is a believer in the former. As we pointed out yesterday, for a unique perspective on deflation as being the catalyst for deleveraging, we refer readers to Andrew Smithers' interview with Kate Welling.

At the crux of the current market risk story is whether or not the troubles in Europe are inflationary or deflationary. If the problems in Europe spread more broadly, it creates a significant headwind to growth that will lead to deflation. Already we are seeing signs that European growth may disappoint initially more optimistic forecasts and for fiscal austerity measures that are needed to reduce debt/GDP ratios (Exhibits 5 & 6). This is the deflation side of the story. On the other hand, the fix to the European situation may result in increased bond issuance, devaluation of the currency, delays in the central bank rate hiking cycle and rising risks for debt monetization. This is the inflation side of the story.

Ultimately, we think inflation wins. In a typical sovereign crisis, there are three common avenues out: growth, inflation or default. We put low probability on default and rapid growth. That leaves inflation. As we see it, the resolution for Greece and the peripherals will come in the form of a fiscal austerity measure combined with some form of capital raise through bond issuance to fund and support the resolution. This brings on the risk of more supply, debt monetization and money supply growth, which is inflationary. Fiscal austerity without a capital raise to support it is unlikely in our view because it may lead to deflation as it did in Japan and create a longer, deeper and more prolonged recession.

If QE, and more specifically the perception of how the Fedis approaching QE, is indeed the catalyst for sovereign credit spreads blowing out, the Fed will undoubtedly be aware of the negative spiral that would result once the peripheral risk shift to Europe's core, and subsequently to America, once, as Hoenig and Plosser demand, MBS purchases are not only halted but in fact sold off (the question to whom is oddly missing - there has not been any material flow into the MBS market from private players over the past year, and in fact we have seen the opposite). Will the end of QE, if it indeed occurs as expected in about 40 days, be the real catalyst for the next leg down? We have long held that particular view, which leads us to believe that the Fed will do all in its power to delay as long as possible the ultimate unwind of all economic crutches. While Goldman is very likely correct about no Fed rate hikes until the end of 2011, we would also add that QE, in some version, will persist well into next year unless Bernanke is willing to go through the September 2008 days all over again. At least practice makes perfect.

 

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Thu, 02/18/2010 - 13:51 | 235627 KidHorn
KidHorn's picture

Like Japan, the FED is trapped. They can't stop QE. The economy is dependent on constant money pumping and there's no way out. The FED may officially announce the end of QE, but I doubt they'll actually stop.

Thu, 02/18/2010 - 13:59 | 235633 Stuart
Stuart's picture

Lets see now how rising rates impacts Federal tax receipts and Federal debt service costs....oh, and that little thing called a national debt.    Any guesses anyone?   rhetorical.    Head, eat tail.  TILT!

Thu, 02/18/2010 - 14:03 | 235643 trav7777
trav7777's picture

Well, two problems.

One is that they are going classic Keynesianist - public credit creation is now carrying the torch where private demand for credit has collapsed.

But, our own debt is incredibly rate-sensitive in the durations that the Fed would have any control over.  We see rates blow out to match our own lack of economic growth and the USG is finished.

Thu, 02/18/2010 - 14:06 | 235648 Stuart
Stuart's picture

agreed, that is why I'm figuring QE has to continue. 

Thu, 02/18/2010 - 20:45 | 236790 jmc8888
jmc8888's picture

Public credit creation isn't Keynesian.  Pubic debt creation is.  Big difference.

Also one must factor in what is created and why.  Keynes didn't understand the why, and thus now the second time around we forgotten the 'what'.  Now we have 'keynes' in spirit through spending, but we forgot 'what' we needed to spend it on.  Because the policy we carried out wasn't Keynes, it was FDR.  Who once the war was over wanted to switch back to a credit system, and end imperialism. He died.  Neither happened.

So the problem is really that they are following someone who didn't know what he was talking about.  Although the alternative schools of thinking don't really get it much better. 

Monetarism

Statistical models (over reliance in lieu of due dilligence)

Derivatives

Talk about a threesome that would make Hugh Hefner blush.

 

However in the here and now, under this system, the end result you state is very plausible.

 

 

 

 

Thu, 02/18/2010 - 13:59 | 235634 buzzsaw99
buzzsaw99's picture

This is a test, it is only a test. If this had been an actually bond market emergency you would have been instructed which channel to tune in to...

Thu, 02/18/2010 - 13:59 | 235636 trav7777
trav7777's picture

Good lord, if credit demand is that low NOW, and the banks attempt to raise rates, wtf is that going to do when all the economic activity now is of negative ROI?

China is a classic example - that is where all the "investment" is going.  OK, so now they have 3 of everything when one was needed for ordinary demand.

How can you lend at >0% when the ROI of the "investment" is negatively profitable?

Thu, 02/18/2010 - 14:00 | 235640 deadhead
deadhead's picture

The Fed is a Toyota gas pedal: cannot.stop.

Thu, 02/18/2010 - 17:40 | 236247 Don Smith
Don Smith's picture

+1! That analogy is to win as politicians are to shit - full of.

Thu, 02/18/2010 - 14:01 | 235641 BS Inc.
BS Inc.'s picture

It's getting to the point where the only real solution is some kind of "Lord of the Flies" revolt by the youth of the West against the Boomers. The level of intergenerational theft going on is downright evil.

Thu, 02/18/2010 - 14:10 | 235649 glenlloyd
glenlloyd's picture

+1 on the Toyota gas pedal.

The real question is did we ever really believe that the Fed would quit let alone extract what they've already pumped into the system?

It's like a leaky dam, if you stick your finger in the hole to stop the flow it's not like it will permanently plug the hole. Once you pull your finger out it starts again, and likely with greater pressure than before.

I don't believe there was ever any doubt that the Fed would continue and that an extraction from this round of intervention was highly unlikely, regardless of the amount of yackity yack we get.

Thu, 02/18/2010 - 14:11 | 235654 jm
jm's picture

As we see it, the resolution for Greece and the peripherals will come in the form of a fiscal austerity measure combined with some form of capital raise through bond issuance to fund and support the resolution. This brings on the risk of more supply, debt monetization and money supply growth, which is inflationary.

 

I'm missing some pieces of the puzzle here.  Since when did Greece get its own printing press?

What reasons do they have to think that ECB (read:Germany) is going to monetize Greek debt?

European policy is as clear as a bell.  Irish medicine is going to be administered to Greece and the other peripheral pals. 

Thu, 02/18/2010 - 14:30 | 235678 Handle with care
Handle with care's picture

Its an interesting question, why now?

I was in Asia prior to the Asian economic crisis and Thailand had been the fastest growing economy on earth with an average growth rate over the previous couple of decades close to 10%.  Its peg to the dollar had been solid for a decade, yet it all came crashing down for no reason yet that has been convincing.  There has been plenty of analysis showing factors in hindsight, such as a current account deficit, real estate bubble, debt to GDP ratios, but they had all been equally as bad for years so nothing that explains why it was in June 1997 that Thailand's currency peg was suddenly considered vulnerable.  

Similarly, there is no obviously causal factor now for the sovereign crisis.  Yes, we can see that there should be a sovereign crisis, but there should have been one a year ago or two years ago, so again, why now.

I personally put a lot of credence in Taleb's analysis of these kinds of events as purely down to chance events acting in non-linear systems.  So a small movement by an individual is normally cancelled out by a multiplicity of other individual actions, but one day it isn't, purely by chance, and its movement is positively reinforcing until its obvious to everyone and has macro effects.

After the event (and now is after the origin) wise heads will say it was obviously bound to happen because of many plausible factors, but in fact they're only covering up their lack of success in predicting it happening by making up post facto explanations to retain their positions as "experts"

 

 

Thu, 02/18/2010 - 15:48 | 235791 BernankeCo
BernankeCo's picture

When folks finally see that they can’t just get someone else to pay for all this, there will likely be a huge tax rebellion
which will cause more short term problems, but may in the long term (hopefully) have the effect of getting the government to manage our money better. In the meantime, let’s hope we don’t have too many large national disasters, military conflicts, pandemics or the like to deal with. This country is in a lot of trouble and we need to start thinking like Americans instead of Republicans or Democrats if we’re going to get through this mess……
Meanwhile experts say the market will crash sometime this year..
Fasten your seatbelts...

Thu, 02/18/2010 - 16:01 | 235871 Going Down
Going Down's picture

 

Les Emerdants Decouvres

 

Naked Capitalism: It's Goldman Sachs and John Paulson

 

Goldman Sachs contre, tout contre, la Grèce Jean Quatremer (hat tip Eurointelligence). I’d translate the piece, but my French is not what it once was (as in I can read it but I might muff some of the finer points). He accuses Goldman and John Paulson’s hedge funds of being the moving forces behind the attack on Greece and the euro:

Je peux donc vous confirmer que, selon des sources concordantes, Goldman Sachs et le fonds spéculatif dirigé par John Paulson seraient les deux principaux acteurs des attaques contre la Grèce et l’euro.

Thu, 02/18/2010 - 19:12 | 236571 Tic tock
Tic tock's picture

Deflation is a desired outcome, perhaps correctly, while Inflation is the outcome which would result when one observes the policy response to date. This sounds too simplistic, yet, in effect, with consumer credit declining -for whatever reason- there is an expectation that the demand will fall and prices will fall to compensate. Which isn't happening yet.

Rebuilding confidence in prices may likely take a fair amount of time. And it looks very much as if the debt inherent in the system is going to cause a crisis before then. Given these pillars, it makes no sense at all why the Federal Reserve and the Treasury would go for policies that have driven the Dollar into Debt monetization so early in the game. Nervertheless, as the President said, 'we need Change we can believe in', not guarantees.

One of the more fascinating elements of the meltdown has been the absence of useful monetary policy. Granted that there was an immediate Debt overhang which prevented fiscal tightening. However, by far and away the greatest push against recessionary forces has come from a media blitz - to which end the much vaunted 'stock market' and those trade flows (commodities) which could be speculated against: 'the fight for hearts and minds', control the perception, control the reality, an illusionist's art. Yet there is a singular flaw in this strategy -which is that the audience has to 'trust' the illusionist. And running a printing press to run out as many dollars as you would like is probably the very last thing that would cause a desperate population to say: see how much like us he is, I feel like I know him. Left hand, right hand, not likely to meet. So the government has done very little to actually alter the course of recession. As in, the banks are there, but they're not actually doing anything. The consumer isn't spending and the employer isn't hiring. House prices aren't going up, 

Furthermore, the breaking of the US consumer pattern could well be endemic of causes separate from the MBS inefficiency. Perhaps the 'problem' is that circle has been, for all intents and purposes, squared with respect to enterprises permissive to high capital flows at the current level of technology: a fully-optimal resource allocation per unit labour. Then (I am assuming a reliance on marginal 'quality' expenditures for demand expansion), even a re-balancing of the traditional input/output price matrix (inflation, or deflationary outcomes) will only serve temporarily, before consumption again becomes saturated. Or, to put it another way, developed markets are maintaining inventories. This would have deep implications for economic growth, specifically -one could interpret some of the last decade's monetary growth as having inflationary aspects- a factor whose propensity to increase will continue if the pre-MBS inefficiencies are retained. 

Of course, the government is trapped by it's liabilities and so has to print money. The smart thing to do would be to initiate deflation, on public sector employees. To instigate a game-changer by introducing low-cost high-level engineering solutions. Retire the current system of unlimited pork, since it's time is over. Sit back, and watch China trip over it's shoe-laces on its way to policeman. 

If this explanation holds sufficient water, then Deflation is not a cerain outcome, because producers are able to maximise profits while having a technological moat that may as well define them as an oligopoly. If this is indeed a proper watershed, then it is 'structural changes' that will equilibriate price perception. 

 

 

Thu, 02/18/2010 - 23:00 | 236986 ATG
ATG's picture

Our parents and grandparents tried to warn us.

Every third generation learns the lesson of

profligate spending inflation leading into desperate deflation saving.

Leviticus described the Jubilee reckoning several millennia ago.

Kondratieff picked it up with economic seasons.

We may be in winter for at least a coupla decades.

http://www.jubileeprosperity.com/

Thu, 02/18/2010 - 23:46 | 237039 Anonymous
Anonymous's picture

Obviously the drain is being pulled on liquidity around the world. In addition to Bernanke's Thursday Surprise (rate hike), don't forget that China is trying to cool things off as well. I would start preparing for some major volatility as all that money starts sloshing around.

Cool trailer:

http://www.youtube.com/watch?v=eD8F0sXEzuQ

Fri, 02/19/2010 - 12:38 | 237638 Anonymous
Anonymous's picture

premeditated malevolence would never be clever enough to hide behind the incompetence label.

Mon, 04/19/2010 - 08:25 | 307578 Tom123456
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