Central Banks

The demand that the ECB becomes the lender of last (and only) resort has reached a crescendo.  Virtually everyone in the world is pleading with Germany to allow the ECB to print money and buy massive amounts of Spanish, Italian, Portuguese, Irish, Belgium, and possibly Austrian debt.  But as far as I can tell, the analysis doesn’t go beyond buy and the problem will be solved.Before taking the step to print, all that we can hope for is that someone will actually do some serious analysis of the potential consequences, beyond the immediate relief rally.It may be the best solution, but until I see some real analysis convincing me the consequences of printing have been thought out, we will remain in the camp that letting some defaults, break-ups, write-downs, is the best longer term solution in spite of short term pain.

Gold Demand Trends (Q3 2011) released today by the World Gold Council (see commentary) shows that investment and central bank demand for gold were key drivers of total gold demand last quarter. Third quarter gold demand increased 6% year on year to 1,053.9 tonnes with investment demand rising a significant 33% y/y to 468.1T. Virtually all markets saw strong double-digit growth in demand for gold bars and coins. Investment demand in Europe surged 135% due to the deepening sovereign debt crisis.  Significantly, 390.5 tonnes of the 468.1 tonnes of investment demand went into physical bullion in the form of bars and coins. ETF demand was 77 tonnes and nearly 50% of that was from European investors and institutions. The increase in overall investment demand was quiet impressive considering the higher average price in the quarter and the price correction in September but not surprising given the scale of the global economic crisis. A huge and paradigm shifting change in the gold market is central bank buying which rose 556% to 148.4T from 22.6T in Q3 last year. For the past 15 years there has been net selling of around 400 tonnes per annum from central banks. Importantly, the World Gold Council can only identify about 40 to 50 tonnes of the 148.4 tonnes bought by central banks.

Physics has the elusive Theory of Everything which consists of several Grand Unified Theories and which represents the holy grail of the science and which "fully explains and links together all known physical phenomena, and predicts the outcome of any experiment that could be carried out in principle." In other words, once proven it would make life boring. We doubt it ever will be. Finance does not have anything like it, for the simple reason that while physics is a deterministic science, finance, predicated to a big extent on assumptions borrowed from the shaman cult known as 'economics' is always and everywhere open ended, and depends just as much on chaotic 'strange attractors' as it does on simple linear relationships. Yet when it comes to presentations, especially of the variety that attempt to explain not only where we are in the world, and how we got there, but also where we are headed, we have yet to see anything as comprehensive as the Investment Strategy guidebook from Pictet's Christophe Donay. If there is indeed a holy grail of presentations, this is it, at least for a few more instants, until something dramatically changes and the whole thing becomes an anachronism. In the meantime learn everything there is to know about global decoupling and the lack thereof, the reality of an over-indebted global regime and its 3 incompatible targets, the outlook for the US and the 30% probability of a hard recession, a recessionary Europe and the five possible outcomes of its crisis, China and its hard landing, and how this all ties into an outlook on where the world is headed together with appropriate investment strategies and proper asset allocation, the fair value of the EURUSD, systemic risk evaluation, cross asset correlation, the impact of central bank intervention, debt redemption profiles, the role of gold and commodities in the new reality, and virtually everything else of importance right here and right now.

Citi's Willem Buiter whose succinct analysis a few weeks ago sealed the coffin of the worthless EFSF, has just come out with another knock out punch this morning after telling Bloomberg TV what everyone else knows is true, but is terrified to say out loud: namely that, "time is running out fast." He adds: " I think we have maybe a few months -- it could be weeks, it could be days -- before there is a material risk of a fundamentally unnecessary default by a country like Spain or Italy which would be a financial catastrophe dragging the European banking system and North America with it. So they have to act now." In sum -  a rehash of the Deutsche Bank pitchbook to the ECB we posted earlier, only in Mutually Assured Terms that would make even Hank Paulson blush. At this point Germany has an option: tell Europe to take a hike, or go balls to wall in bailing out 250 million European's early retirement packages. The ball is in Merkel's court, who unlike Citi, JPM, DB, and everyone else, has to worry about this fickle, and potentially pitchfork bearing, thing called "voters."

And in lieu of any rumors out of Europe (they have all been exhausted, plus nobody believes anything out of the doomed continent), here is our own Fed with its best attempt to talk the market up:

• ROSENGREN: CRISIS MIGHT WARRANT COORDINATED ACTION BY FED, ECB
• ROSENGREN SAYS FED SHOULDN'T BE DISSUADED FROM TRYING TO HELP

And yet:

• ROSENGREN: CENTRAL BANKS CAN'T SOLVE ECONOMIC PROBLEMS ALONE

So who steps in: aliens?

Gas up, other retail sales down.

As the ECB remains the liquidity provider of last and only resort, we suspect the oh-so-transparent central bank is causing some banks to avoid it and look to the cross-currency basis swap market to fund themselves in USD as the 3 month EUR-USD swap reaches 126bps (-6bps more today). These levels are the lowest (widest and most USD desperate) since December 2008 and perhaps, away from the SMP-driven sovereign spread markets, are the cleanest and least interfered with market view of the extraordinary USD funding crisis that is occurring. These stresses are just as evident in the GC repo markets and Goldman agrees with us that this crisis is escalating and offers a primer on why the GC repo / Libor markets are dysfunctional currently.

Even by a quick back of the envelope analysis, we find ourselves in an environment in which a single corporation such as Exxon is actually more trustworthy (from an investment perspective) than US Treasuries.

The following note from JPM's Ken Landon summarizes what, in the aftermath of an ECB which as Yves Mersch just noted, will not intervene in the markets due to the realization that monetization will bring about the 4 horsemen of the apocalypse, is the greatest threat to investors: political instability, manifested either formally in the form of elections, or informally, in the form of occupations, riots, revolutions, civil wars, alien invasions, etc. And of course, to JPM, just like to everyone else threatened by the upcoming end of the status quo, the bad guy suddenly is the ECB, which had made it all too clear since inception it will not monetize debt. Yet somehow now that we are approaching the endgame it appears this was not very clear. So the plan is to shame them into monetizing everything, Weimar flashbacks be damned. To wit: "The ECB does not operate in a political vacuum. It is the only entity that has the capacity to be the lender of last resort in the Eurozone. Without this, the Eurozone does not have much longer to exist. It will implode. With the ECB decidedly on the sideline, investors are reduced to the state of having to read the tea leaves of national politics. For example, today and tomorrow are crucial days for the formation of the Monti-led government in Italy. Will he be given a strong mandate? Even if he is, will the new government be able to come up with a credible plan that investors will have confidence in?... Greece remains a wild card with the main opposition party refusing to sign a declaration of support of the October agreement.  When politics dominate markets and economies, you can be sure that uncertainty will reign and that growth will suffer." So without further ado, here is the complete list of what to look for in the next several months on the all too critical political front, courtesy of UBS.

The global economic situation is becoming more dire every day.  Approximately half of all US banks have significant exposure to the debt crisis in Europe.  Much more dangerous for the US taxpayer is the dollar's status as reserve currency for the world, and the US Federal Reserve's status as the lender of last resort.  As we've learned in recent disclosures, this has not only benefitted companies like AIG, the auto industry and various US banks, but multiple foreign central banks as they have run into trouble.  Nothing has been solved, however, by offering up the productivity of Americans as a sacrificial lamb.  Greece is set to be the first domino to fall in the string of European economies at risk. ...The US has a relatively small exposure to overwhelmed Greek banks, but much larger economies in Europe are set to follow and that will have serious implications for US banks.  Greece is technically small enough to bail out.  Italy is not.  Germany is not.  France is not.  It is estimated that US banks have over a trillion dollars tied up in at-risk German and French banks.  Because the urge to paper over the debt with more credit is so strong, the collapse of the Euro is imminent.  Will the Fed be held responsible if the Euro brings the US dollar down with it?

And to think, some people think I'm pessimistic!

One of the last remaining Germans at the ECB, Jens Weidmann, gave an interview to the FT earlier today, in which the president of the Bundesbank, shared some pragmatic responses to questions about the depths of ECB intervention in the capital markets. The man who on Tuesday clinically stated explicitly that the "ECB can't print money to finance public debt" (to which he adds today that "this is a very fundamental issue. If we now overstep that mandate, we call into question our own independence"... odd, never prevented the Fed from questioning its own independence), follows up with some much needed clarity on just where the ECB sees itself in the coming weeks and months, touches on the rumor that sent stocks surging on Friday, namely that it would proceed to fix interest rates (it won't), and shares some rather amusing observations on the recent revelation that the ECB has become a weapon of political (de)stabilization: after all it took the ECB's bond buying program - the SMP - just two days of not buying Italian bonds for Silvio Berlusconi to resign after BTPs hit an all time rock bottom price. Yet the most amusing slap in the face of the Eurocrats is precisely what we mock every single day, namely the perpetually changing nature of the EFSF on a day to day basis, confirming the cluelessness of the continent's leaders, and which has cost Europe all credibility in the face of capital markets, explaining why the EFSF has to resort to not only buying its own bonds, but issuing terse statements denying anything and everything: "EU governments have decided how to finance the EFSF. They agreed on guarantees for the EFSF and, in their last meeting, on two options on how to leverage the EFSF – by an insurance model or a special purpose vehicle. Instead of working on implementing these approaches, we now have the next idea that is completely out of the realm of what has been discussed previously. I don’t think it builds confidence in crisis resolution capabilities if from week to week, from one meeting to the next, you are questioning your last decision."

The 'tragedy of the commons' or 'free-rider' dilemma of game theoretical cocktail parties is a great framework for considering the current tug-of-war between individual sovereign fiscal actions among the European Union and the over-arching monetary policy of the ECB. If the ECB is dovish and too many states decide to suckle on the teat of liquidity - as opposed to fiscally 'behave' - then everyone loses (as we see currently evolving). The lack of any Nash (stable and dominant) equilibrium among the European nations and their hoped-for benefactor is becoming increasingly problematic for both trading and business investment.

Nomura's Global Macro Strategy group tackle the problem that is now abundantly clear, the euro area as currently constructed is not stable and so it will have to change (hence, the Euro is dead!). The direction of travel is being set out by northern European politicians and is worth noting – more Union not less. But two points are critical to note; first that the new euro area may be so different from the one the current members signed up to as to make a process of voluntary re-application for euro stage II necessary to determine future membership, and second that any new variable geometry euro will take a long period of time to set up. How then to cover the intervening period?

Without credible pre-commitment on the part of either the ECB or the fiscal authorities, the game framework indicates either a loss of independence for the ECB under substantial political pressure to shift unilaterally to the dove camp or EFSF/IMF assistance and the pooling of fiscal risks against the backdrop of a political agenda for a new euro area.

It is no secret that over the past two months, Goldman has commenced a full endorsement of Nominal GDP targetting as a method to stimulate the economy, not to mention Wall Street's bonus pool, after Ben Bernanke completely ignored Hatzius' advice to reduce the Interest on Overnight Excess Reserve rate as well as subsequent pleading for a start of MBS LSAP. Mathematics once again aside, and as we demonstrated, the math works out to an non-trivial incremental $10 trillion in debt through 2016 on top of what will be issued, to catch up with the GDP growth run rate and to eliminate the excess slack in the economy, the question is whether NGDP would achieve any tangible stimulus at all, or merely reduce the Fed's ever smaller arsenal of non-conventional means to boost the economy by one more approach. The attached rhetorical Q&A just released by Goldman seeks to answer that and any other left over questions one may have on NGDP as a policy measure, and further puts out the inverse strawman argument that it is not coming out any time soon. To wit: "We do not expect a move to an NGDP target anytime soon, although the probability would increase if growth and/or inflation slowed by more than we currently estimate." Then again, with the whole reverse psychology trademark inherent in every piece of Goldman public product, and considering the squid's previous advances to determine monetary policy have been snubbed, it may just mean that the next time the US economy implodes, this is precisely the method the Fed may use in early 2012 to guarantee another record year of Wall Street bonuses considering 2011 will be abysmal for so many Swiss and other offshore bank accounts.

The spike in yields on sovereign debt of Italy was attributable, only in part, to the Italian political turmoil we are witnessing. The other aspect dealt with CDS on Italian debt. Those holders thought they had one type of CDS protection. They realized from the events in Greece that they had something else.