Sovereign Debt

The European Central Bank prints money and hands it to the banks in undiminished size and at an interest rate which compels massive carry trades. The European banks buy sovereign debt that helps to lower the price of the sovereign’s funding costs, the banks use some of the money to increase their own capital and lend some of the money to individuals and corporations in the nations where they are domiciled. The money gets used and eventually dries up and a some of the capital is used to come into compliance with Basel III. The yields of the periphery nations fall but then begin to rise again. Germany, using Target-2, keeps lending money to the other central banks which use part of the money to support their currency, the Euro. The circle is then completed and the equity markets, notably in America, trade off of the strength of the Euro and some days at almost a point by point movement. Never before in the history of the world has such a grand scheme been implemented and in such an all-encompassing fashion. The unlimited amount of money that is available, because they can print all the money they want, has allowed Europe to game the world’s financial system while no one looked or caught on to the scheme. The world’s fiscal system has been rigged by Europe.

The question puzzling currency markets is why the EUR is so strong.  While we have argued that during the risk-off period of the last month or so post-LTRO2 (before Tuesday) EURUSD strength appeared to be driven by repatriation flows and balance sheet reduction, new information over the last couple of weeks driving the expectation that growth will be weak enough in the US to keep US policy very stimulative for a nice long time, we tend to agree with Steven Englander of Citigroup who argues that it looks very much as if QE3/Fed-stimulus anticipations are behind the EUR relative strength recently. Indeed the recent USD weakness is pretty much across the board, suggesting that it is less EUR attractiveness than USD unattractiveness that is driving the EUR’s gains.  That said, I think the buzz around various euro zone measures to help out banks and ease the rigidities of the fiscal compact is also helping support the EUR by reducing tail risk, but right now the USD/Fed is the bigger story. Back of the envelope math based on the Fed/ECB balance sheets and EURUSD implies the market expects  around $700bn of QE3 and given swap-spread differentials there appears to be little liquidity premium to reduce this expectation.

The balance sheet recession diagnosis of many of the world's developed nations remains among the clearest explanation linking the failure of textbook monetary policy to the dismal multipliers, transmission mechanism breakages, and sad reality of a recovery-less recovery. Whether you agree with Richard Koo's traditional but massive Keynesian fiscal stimulus medicinal choice is a different matter but the Nomura economist delineates the three problems (two macroeconomic and one capital flow) exacerbating the eurozone crisis and notes that "bulls have gotten ahead of themselves". Noting that the central bank supply of funds may help address financial crises but cannot resolve problems at borrowers, and that authorities have never admitted they were wrong, Koo stresses the three key reasons that bullish speculation on eurozone is premature - monetary accommodation's ineffectiveness when the private sector is deleveraging, active fiscal retrenchment by the core when fiscal stimulus is the only plus for aggregate demand, and Japanese and US lagged-examples of that dash any short-term hope that structural reforms will lead to growth. Even his solution to the European debacle - one of financial repression limiting the sale of government bonds to each nation's own citizens - while retroactively limiting a nation's largesse seems to only lead to the inevitable Japanification we have discussed at length. In the meantime, Koo appears far less sanguine than the markets about the prospects for anything but further demise in Europe (and the US).

Better late than never. All you need to read. 

Between credible and non-credible political and fiscal policies and a reflationary or deflationary monetary policy aimed at the financial system, Morgan Stanley provides a quick-and-dirty 'map' of where Europe finds itself and the four different scenarios that await this troubled region. The 'Quantum Leap' of credible fiscal integration with term liquidity support and even easier monetary policy is where everyone hoped we would be by now (especially post the October 26th Grand Plan decisions). However, the sad truth in reality is the drop in credibility of political will (or direct nationalism emerging) combined with some concerns over inflation and the dramatic fading of the liquidity impact of the ECB's latest actions means we are drifting rapidly towards 'Debt Crisis Derailment' as the elite continue to confuse insolvency and illiquidity and stick their heads in the sand with regard the reality they face under the restrictions of Maastricht. With implicit monetary conditions dramatically easy and peripheral banks over-stuffed with sovereign debt, there is little room for anything but more encumbrance or ECB-Treaty-busting direct printing (which is the rumor floating all boats this morning).

• Hollande Says Germany Can’t Make Europe’s Decisions Alone (BBG)
• Monti Hits at Eurozone Austerity Push (FT)
• Firm that made loans to Chesapeake CEO defends them (Reuters)
• Bo Xilai's Son Doesn't Drive a Ferrari. He drives a Porsche (WSJ)
• Geithner Urges China to Loosen Hold on Finance System (BBG)
• and yet... Son of Bo Xilai Says Father’s Ouster ‘Destroyed My Life’ (BBG)
• U.S. growth slows as inventory accumulation wanes (Reuters)
• S&P 500 Dividend Payers Climb to Highest in 12 Years (BBG)
• Lacker Sees Fed May Need to Raise Rates in Mid-2013 (BBG)
• Ireland Passes Latest Bailout Review (WSJ)

In a week that Spain can't wait to end, the country was just hit with the bad news bears Trifecta, starting with the Real Madrid loss, following with the second S&P downgrade of Spain's credit rating for the year last night (or is that now SBBB+ain?), and concluding with economic data released this morning which showed that the economy is in a free fall that is approaching that of Greece, after retail sales fell for the 21st consecutive month, while Q1 unemployment soared to, drumroll please, one quarter of the working population or 24.44% to be specific, trouncing consensus estimates of 23.8%, and up nearly 2% from the 22.85% as of December 31. Which likely means that the real unemployment is far higher, and confirms not only that the economy is in free fall mode, but that Moody's, which delayed its downgrade of the country's banks to May, will proceed shortly.

UPDATE: *S&P TO ASSESS EFFECTS OF SPAIN DOWNGRADE ON SPANISH ISSUERS

Adding insult to Bayern Munich injury, we just got S&P which did the impossible and cut Spain to BBB+ from A (outlook negative) not on Friday after hours. Kneejerk reaction is a 30 pip drop in EURUSD. Oh, and most amusing, those witches among men, Egan Jones, downgraded Spain from BBB to BBB-.... a week ago. Crush them, destroy them... How dare they be ahead of the pack as usual: after all their NRSRO application was missing a god damn comma.

If central planners decide to circumvent the already manipulated bond market and enforce much lower interest rates by implementing forced loans, there would be a big uproar for some time in the market. However, the negative wealth effect on the private sector would be more foreseeable and stretched out over a longer period of time. This definitely would decrease uncertainty. In my opinion, this measure would actually help to break through the downward spiral and avoid the much more devastating course towards a restructuring event with its negative side effects.

Sampling several investment banks' opinions on what to expect out of today's FOMC decision in a few hours, one would be left with the impression that absolutely nothing will happen. Not surprisingly, this is what the official party line reps and warrants as well, as telegraphed by that faithful mouthpiece, Jon Hilsenrath. And yet if the Fed has finally understood that its role is only effective if it is surprising, this gives all us all the opportunity to not only doubt what the media and the sellside wants us to expect, but to naturally fade Goldman - one of the best trades in the past three years - who says: "We expect no clarity from Wednesday's FOMC statement and press conference on additional monetary easing. Fed officials will not close the door but are also unlikely to provide a clear hint of further action. Our forecast of additional easing hinges not on what Fed officials say this week, but on our expectation of continued weakness in the economic data." Of course it is possible that the Fed is merely staying true to its recent creed of being honest and transparent and telegraphing policy from miles away. And is thus forced until the market is actually driven by actual macro data instead of who buys how many gizmos using student loans. Or not. Because when in doubt, always ask i) what would Goldman Sachs sell and ii) what would PIMCO buy. The two are rarely both wrong at the same time.

The ECB has found its hands tied: if it continues to monetize aggressively, inflation will surge and Germany will either leave the Euro or at the very least make life very, very difficult for the ECB and those EU members asking for bailouts.

After all, doing this would score MAJOR political points for both Merkel and Weidmann who have both come under fire for revelations that the Bundesbank has in fact put Germany on the hook for over €2 trillion via various back-door deals.

It's easy to expand the money supply and difficult to expand the actual production of real goods in the real world. Expanding the money supply and issuing debt that lacks collateral is just like printing quatloos on the desert island: you can print a million quatloos but that doesn't create a single additional coconut. If you print enough quatloos, then people will no longer accept them in exchange for coconuts. You will actually need a real coconut to exchange for fish. This is why Greek towns are reportedly reverting to barter, the exchange of real goods for other real goods. We can anticipate that silver and gold will soon enter the barter as means of exchange that can't be counterfeited or printed by wise-guys (central bankers).This is what happens when abstract representations, i.e. "money," vanish into thin air. Alternative systems of exchanging goods and services arise: actual goods are exchanged via barter, tangible concentrations of value that cannot be counterfeited such as gold and silver are used as a means of exchange, letters of credit or equivalent are traded and settled with tangible goods or gold/silver, and eventually, a means of exchange ("money") that is backed by tangible goods in the real world that can be trusted to actually represent the value being traded might enter the market. That which is phantom will vanish into thin air, while the real goods and services remain to be traded in the real world.

Remember when Lehman or Bear Stearns was 'too small' to matter and 'subprime was contained', we we are getting same ignorant first-order analysis now with regard Spain (or more broadly-speaking Southern Europe). The whole of Southern Europe is only 6% of global GDP - how can that matter? (especially when we can eat iPads?) Michael Cembalest, of JPMorgan, provides some much needed sense on why these small countries pack a large disruption risk punch for global markets and economies. By breaking down the world into a few categories of disruption risk, the JPM CIO notes that the southern strain of Eurovirus has a much larger non-proportional impact thanks to transmission risk via its significantly greater share of sovereign and bank debt relative to the world and how these debts are financed. The transmission risk to the much-larger Northern Europe is material. We are already seeing Germany's new orders from within the Euro-zone slumping and this week's business sector surveys were very weak. As Cembalest concludes, from an alien's perspective, Earth may be able to outrun the collapse in Europe’s periphery if the ECB keeps printing money and the IMF increases its firewall, but it’s not going to be easy.

Austerity is dead!  Long live Spending! Futures are up, Italian and Spanish bonds are up, CDS spreads on them are at least 10 bps tighter, and MAIN is 3 bps tighter on the day (though I have this feeling I better type fast as we are starting to fade off the best levels). Lots of little things seem to be contributing to the strength, TXU earnings, no economic data, auctions that raised the required money, etc., but there does also seem to be a belief that Germany finally “gets it”.  That Germany is finally going to relent on their demands for austerity. So “Austerity Now” may be over, but killing something that didn’t work, isn’t the same as solving the problem.  Going back to the norm that caused the problem in the first place, hardly seems like a solution either.  Currency reversion and/or debt restructuring will be the ultimate end-game.

As usual the market remains on tenterhooks for its next fix of Central Bank largesse and the following 11 days provide some rather large potholes for those addicted to the sweet nectar of freshly printed extreme monetary policy. Citi's Steven Englander provides some much-needed reality checking on what the market is expecting and what the FOMC/ECB might deliver, and all importantly, what the implications for risk-assets in general will be. The possibility of misunderstood language at the FOMC meetings seems very high even as the announcement of additional measures remains unlikely and perhaps more notably the Euro has sold off sharply when the ECB does not present a policy response to rapidly deteriorating market conditions - especially in light of the implicit tightening we have seen in Euro-zone aggregate rates. Rock meet hard-place.