Sovereign Debt

The theory of Petrodollar Warfare can be attributed to US analyst and author William R Clarke, and his 2005 book of that title which interpreted the US-UK decision to invade Iraq in 2003. He called this an "oil currency war", but the concept of the petrodollar system and petrodollar recyling dates back to the eve of the first Oil Shock in 1973-1974. The role of the petrodollar system as a driving force of US foreign policy is explained by analysts and historians as basic to maintaining the dollar's status as the world's dominant reserve currency - and the currency in which oil is priced. Today however, with the major and massive changes of oil resource availability revealed by the shale energy revolution, rising global oil production capabilities, stagnating oil demand, and rising renewable energy supplies in all major developed countries, and the constantly declining role of oil in the economy, the Petrodollar System's days are surely numbered

Need a quick GDP boost in a world in which the uber levered consumer is tapped out and has no more savings or purchasing power, in which the government is facing an existential socialism or bust crisis even as global sovereign debt levels are at unseens before levels, and in which global trade has collapsed (so there go the C, G and (X-M) components of GDP)? No problem, just add some I for Inventory. Better yet, add a whole lot of I, especially if you are that global growth dynamo, China, which over the years many have accused of having taken the term "overcapacity" and put it through the Barry Bonds juicer yet where courtesy of a central-planning regime that has made sure nothing appears to be unused, except for the occasional ghost city or empty mall, proof of such overcapacity has been scarce in official, government data.

Evans Quote #1: "Chicago Federal Reserve Bank President Charles Evans on Monday reiterated his belief that the US economy will begin to turn around in the second half of this year. "We think conditions will improve in the second half of this year,"

Evans Quote #2: "The sovereign debt crisis that has enveloped three European nations and threatens to spread to others will slow U.S. economic growth, but the impact will be “minimal to modest," the president of the Federal Reserve Bank of Chicago said Friday.

Evans Quote #3: Chicago Fed’s Evans comments in speech in Chicago: "economy improving quite a lot; companies seem to be in pretty good shape. Optimistic [XXXX] Will Be Year of Turnaround; US growth will be self-sustaining in [XXXX+1]"

There has been a growing shift in favour of assets relative to bank deposits. This was initially encouraged by zero interest rates, but more recently there is little doubt that Cyprus’s bail-in has accelerated the trend. This helps explain why, for example, Italian 10-year bonds are on a 4% yield. The reason, doubtless reaffirmed by the Cyprus bail-in, is that investors with cash balances think over-priced sovereign debt is less risky than adding to their euro deposits. However, some of depositors’ cash balances post-Cyprus will have gone into physical gold and silver, which explains why the bullion banks operating in the futures markets and the central banks behind them are so keen to dissuade us that gold and silver is a safe haven.

"Preservation of Capital," has reached epic seriousness in a world with interest rates at unsustainable lows and underlying economic fundamentals that cannot support today's yields. The irrational game goes on based upon one thing and one thing only which is the creation of capital by all of the world's central banks. The money must go somewhere and so it does but the disconnect between the equity markets and bond yields from the real world is frightening. Nowhere on the planet is it scarier than in Europe.

This morning we were treated, once again, to confirmation that Europe is still in the middle of a deepening crisis. No, this was not a reflection of the terrible data, it was Mr. Hollande's insistence that "the crisis is behind us." Luckily we have a foil for this idiocy. Bernard Connolly, author of 'The Rotten Heart of Europe' explains to CNBC's Rick Santelli, "the point is that the union has produced this disaster; and the people who put the disaster in place hail it as a success. are they crazy? If they are, that's pretty disturbing! If they're not crazy, then the question of why they have done it is more disturbing." In a few brief minutes, uninterrupted by an anchor desperate for silver linings, Connolly explains to Santelli when asked of the future, that nothing will change in the short-term, "the potential ways of getting out of the mess are simply unthinkable," to both beggar and chooser, adding that "you have a cycle of deflation, depression, default, more banking crisis, more sovereign debt crisis, and social and political crisis." Simply put, Connolly concludes on social unrest, "I don't see any way of avoiding it."

“There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money. Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.”

In the beginning there were a handful of core nations equal in partnership and full of the excitement of a new venture. Much of the esprit was a desire to band together and compete against the United States for economic dominance and world power. Now we find the EU headquarters no longer staffed by equals but a useful front for Berlin which resides in another country. This point is critically important to understand. Yes, sure, the Germans will smile and nod and give way on agricultural supplements and on fishing rights and trivial matters but when it gets down to it and the decision is important; Berlin will have its way. The fact that the equity markets have done fabulously and that the interest rates for European sovereign debt have done remarkably well all rest on one thing and one thing only; the creation of money and a massive amount of it. Europe, and the rest of the world for that matter, has been transformed by the printing of money. The dislocation between economies and markets is huge and the glue is the twenty-four seven machinations of the printing presses. Politicians in Europe and America have taken a back seat to the heads of the world's central banks. Lastly, as I stare out at the horizon, you should understand the German viewpoint of the State. You win by being in control and control must always be exercised and never relinquished.

With equity valuations no longer levitating but in a different, 4th dimension altogether, and credit spreads compressing dramatically (and unreasonably)... It is in situations like these, when the crash comes, that the proverbial run for liquidity forces central banks to coordinate liquidity injections. However, something tells me that this time, the trick won’t work. Over almost a century, we have witnessed the slow and progressive destruction of the best global mechanism available to cooperate in the creation and allocation of resources. This process began with the loss of the ability to address flow imbalances (i.e. savings, trade). After the World Wars, it became clear that we had also lost the ability to address stock imbalances, and by 1971 we ensured that any price flexibility left to reset the system in the face of an adjustment would be wiped out too. From this moment, adjustments can only make way through a growing series of global systemic risk events with increasingly relevant consequences. Swaps, as a tool, will no longer be able to face the upcoming challenges. When this fact finally sets in, governments will be forced to resort directly to basic asset confiscation.

One possibility for the markets to reverse has always been some grand event but another is just the economic deterioration that wears away at the markets as current levels cannot be rationally supported. It is not just the Law of Diminishing Returns which is coming into play as the central banks create more money but the effects on the consumer of seriously declining available cash to be used to purchase goods and services.  We have been subject to a massive amount of monetary printing and an unconscionable manipulation of data but the affects of reality cannot be ignored forever because reality forces the consequences as the fantasy gives way over time.

The highlights from Bill Gross' monthly letter: "The past decade has proved that houses were merely homes and not ATM machines. They were not “good as money.” Likewise, the Fed’s modern day liquid wealth creations such as bonds and stocks may suffer a similar fate at a future bubbled price whether it be 1.50% for a 10-year Treasury or Dow 16,000.... if there are no spending cuts or asset price write-offs, then it’s hard to see how deficits and outstanding debt as a percentage of GDP can ever be reduced....  Current policies come with a cost even as they act to magically float asset prices higher, making many of them to appear “good as money”. And the take away: "PIMCO’s advice is to continue to participate in an obviously central-bank-generated bubble but to gradually reduce risk positions in 2013 and perhaps beyond. While this Outlook has indeed claimed that Treasuries are money good but not “good money,” they are better than the alternative (cash) as long as central banks and dollar reserve countries (China, Japan) continue to participate....a bond and equity investor can choose to play with historically high risk to principal or quit the game and earn nothing."

In the past months and right after implementing Quantitative Easing Unlimited Edition, the Fed began surfacing the idea that an exit strategy is at the door. With the latest releases of weak activity data worldwide, the idea was put back in the closet. However, a few analysts have already discussed the implications of the smoothest of all exit strategies: An exit without asset sales; a buy & hold exit. We have no doubt that as soon as allowed, the idea will resurface again. Underlying all official discussions is the notion that an exit strategy is a “stock”, rather than a flow problem, that the Fed can make decisions independently of the fiscal situation of the US and that international coordination can be ignored. This is logically inconsistent as we address below...

All of the EU “hails, welcomes and applauds” the new Italian government. Mr. Grillo thinks that the new government will last but a few scant months as Europe breathes a sigh of relief that the 5 Star Party is not in control. Far better to deal with the devils that you know rather than new ones that may be far worse. Beyond the politics of the moment Italy is besieged by a very serious crisis. As the various central banks dump money into the system the yields on Italian sovereign debt have gone down but this does not change the economic difficulties. Italy’s difficult position was enumerated in a Bank of Italy report to parliament last week which said the economy was going through its most acute crisis since World War II. Mr. Grillo’s response to the new government was amusing: “An orgy worthy of bunga bunga.”

We have commented numerous times on the inexorable rise in Spanish non-performing loans (NPLs). Since the Spanish economy started to weaken at the end of 2006, NPLs have been rising sharply; but the subsequent collapse of the Spanish property market exacerbated the matter further, causing a spike in NPLs in 2007 and 2008. Since then, the Euro area crisis and subsequent sharp rise in unemployment have led NPLs at Spanish banks to make new record highs. However, they are not alone. Italian banks did not suffer a property market collapse and so the rise in NPLs started later than in Spain and was not as severe. However, as JPMorgan notes, the sharp rise in unemployment we have seen since mid 2011 has led to an acceleration in NPLs at Italian banks. What should be most worrying for incoming PM Letta, is that from the respective troughs for each country (the trough for Spain was a lot earlier than for Italy, about two years in actual fact), Italy is looking eerily similar. The rise in NPLs at Spanish banks over the past two years has had a lot to do with the recession and rise in unemployment. To the extent that Italian unemployment has only started to rise sharply a year and a half ago, the future path for NPLs at Italian banks looks set to follow that of Spain. So why aren't bond spreads blowing wider? Answer below...

Moments ago, PD's Enrico Letta announced that after several days of negotiations he has enough support to form a government which will see Letta as Prime Minister, while one of Silvio Berlusconi's closest allies, Angelino Alfano, of Berlusconi's PDL, would become deputy prime minister and interior minister, in effect guaranteeing Bunga immunity from any and all political and criminal prosecutions for as long as the government is in power. Reuters also informs that "Bank of Italy director general Fabrizio Saccomanni will take the powerful economy ministry and former European Commissioner Emma Bonino will be foreign minister, Letta said after meeting President Giorgio Napolitano. The government will be sworn in at 1030 BST on Sunday and Letta is expected to go before parliament to seek a vote of confidence on Monday." In other words, the new Italian government will cover all bases: it will be anti-austerity as per Letta campaign to give the people hope that things may get better as much more debt is issued, Berlusconi will be safe and sound, which was his only real mandate, and the Italian Banks will remain in the good graces of the ECB as the link between the financial sector (which has been buying up record amounts of Italian sovereign debt) and the nation becomes inextricably linked, something Europe once upon a time tried to avoid but no longer pretends to even care.