Between the thinness of European bond markets during the summer doldrums and the hair-trigger momo-monkeys, it would appear that all the hopes and prayers of the Draghi "promise" have been more than priced into the Spanish bond curve already. Of course, short-dated yields could drop further on ECB buying; but where exactly 'should' that risk premia be? Of course, longer-dated yields could compress but does anyone really see a solution here, as opposed to short-term support to get through some debt maturities and avoid a catastrophic contagion? The critical point being - for all the anticipation of Draghi's bond-buying plan and its implicit conditionality, the Spanish yield curve has priced it all in and more - as the 2s10s curve is now at all-time (pre- and post- Euro-era) record steeps. We have seen this pattern before - into and during LTRO - that did not end well; and the crowd is getting larger and doors smaller in this one (and don't forget Corzine won't be your fall-guy this time)...
We destroyed the myth that the LTRO would not in fact stigmatize bank balance sheets when it was first introduced as the encumbrance was evident from the start - though took the market a while to comprehend and reprice (exuberant on the new-found liquidity optics). The expectations that the ECB will embark on a new scheme of sovereign debt purchases, implicitly funding governments - no matter how many times they tell us that it is to ensure transmission mechanisms flow, have three objectives or rationales, according to Goldman's Huw Pill: Easing private financing conditions through monetary expansion, Financing governments, and/or Reactivating private markets. However, there is one glaring unintended consequence of this 'aid' - the risk exists that well-intentioned sovereign debt purchases result in perverse incentives and a perpetuation of chronic fiscal and structural problems (much as Bernanke's band-aids have eased the fiscal pressure on our own government and led us further down the rabbit hole). The lack of political legitimacy and blunting of incentives for more fundamental consolidation and reform to take place can only turn the acute pain of the moment in Spain into a truly chronic problem for Europe as a whole - be careful what you wish for.
The bow-tied-and-bespectacled bringer-of-truth was on Bloomberg TV this morning providing his own clarifying perspective on what we should hope for (and what we should not) from J-Hole this weekend. Jim Grant's acerbic comments on Krugman's view of the world, on the gold standard as a "force for growth and stability", and the "unproven and truly radical methods" of the SNB and Fed, pale in significance when he is asked about the stock market distortions: "I think we live in a hall of mirrors in finance thanks to the zero interest rate regime and the chronic nonstop interventions," and when asked when Bernanke should start raising rates, the simple (yet complex) response is "Last Year! And Eric Rosengren would be in a different line of work." Must watch to understand the central-banker-meme-du-decade.
Speculation that the ECB might, as part of its proposed bond-buying programme, announce an interest rate target (or band) for short-dated peripheral government bonds has sparked a further rally in Spanish and Italian bonds in the past week. Such an 'unlimited' move is a complete volte face from past policy, but Daiwa's research team believes hopes that the announcement of an interest rate or spread target would spare the ECB the pain of having to intervene in the markets at all are flawed in our view. For the ECB to credibly communicate an interest rate or spread target requires it to quantify the excess risk premia. Given the inherent inaccuracy (or falsehoods) of the forecasts underlying these estimates, the ECB would risk having to review these targets regularly, leaving markets uncertain about their permanence. The success and the sustainability of any future ECB interventions will ultimately depend on the peripheral governments’ ability to meet the conditionality required - and we know how that has ended up - always and every time.
With the market realization slowly dawning that Bernanke will not announce anything of note at this year's Jackson Hole meeting, especially with the NFP number following the symposium expected to demonstrate another improvement in the economy, and ahead of the FOMC meeting in the second week of September, many hopes were resting on the shoulders of Draghi, whose ECB has now become a backup option when it comes to jawboning markets higher on empty promises. It is the same ECB which is also expected to announce something, anything on September 6, or else the market will really get angry after "believing" Draghi back in July as he said, and not delivering anything for two months straight. At this point however, the Jackson Hole meeting appears to be a complete dud because as was just reported, Mario Draghi, who was previously scheduled to speak on August 30, has decided to skip the meeting entirely. According to Bloomberg, citing an ECB official, Draghi won’t be attending Jackson Hole forum this year, and the reason given is "due to workload in coming days."
In the euro area overnight rate targeting has produced roughly a 130% expansion of the true money supply in the first decade of the euro's existence – about twice the money supply expansion that occurred in the US during the 'roaring twenties' (Murray Rothbard notes in 'America's Great Depression' that the US true money supply expanded by about 65% in the allegedly 'non-inflationary' boom of the 1920's). This expansion of money and credit is the root cause of the financial and economic crisis the euro area is in now. This point cannot be stressed often enough: the crisis has nothing to do with the 'different state of economic development' or the 'different work ethic' of the countries concerned. It is solely a result of the preceding credit expansion. Since long term interest rates are essentially the sum of the expected path of short term interest rates plus a risk and price premium, the central bank's manipulation of short term rates will usually also be reflected in long term rates. In the euro area's periphery, the central bank has lost control over interest rates since the crisis has begun. The market these days usually expresses growing doubts about the solvency of sovereign debtors by flattening their yield curve: short term rates will tend to rise faster than long term ones. This in essence indicates that default (or a bailout application) is expected to happen in the near future. It is possible that this effect has also influenced the ECB's decision to concentrate future bond buying on the short end of the yield curve. However, as is usually the case with such interventions, there are likely to be unintended consequences.
When we wrote Part I of this paper in June 2009, the total U.S. public debt was just north of $10 trillion. Since then, that figure has increased by more than 50% to almost $16 trillion, thanks largely to unprecedented levels of government intervention. Once the exclusive domain of central bankers and policy makers, acronyms such as QE, LTRO, SMP, TWIST, TARP, TALF have found their way into the mainstream. With the aim of providing stimulus to the economy, central planners of all stripes have both increased spending and reduced taxes in most rich countries. But do these fiscal and monetary measures really increase economic activity or do they have other perverse effects?... The politically favoured option of financial repression and negative real interest rates has important implications. Negative real interest rates are basically a thinly disguised tax on savers and a subsidy to profligate borrowers. By definition, taxes distort incentives and, as discussed earlier, discourage savings.... The current misconception that our economic salvation lies with more stimulus is both treacherous and self-defeating. As long as we continue down this path, the “solution” will continue to be the problem. There is no miracle cure to our current woes and recent proposals by central planners risk worsening the economic outlook for decades to come.
The initial boost given to European equities following weaker than expected overnight data from China, which renewed speculation of more stimulus measures, has faded throughout the morning. The major European bourses are now trading in negative territory at the North American crossover. The DAX is underperforming, weighed down by the likes of Commerzbank and Deutsche Telekom who both failed to impress markets with their earnings reports pre-market. However, thin summer volumes and another light economic calendar have once again been the theme for the morning, with only the UK Trade Balance for June gaining some market attention. Despite the larger than expected deficit, the ONS said that the figure is likely distorted by the extra public holidays.
You may recall that one of the “tricks of the trade” was the use of people in the audience. They stood up and claimed that they had taken the magic potion and were cured of rheumatism, arthritis, cancer and that ninety year old Uncle Elijah and been able to throw away his cane after imbibing the stuff. This may remind you of what is going on in Europe presently as politicians from each and every nation claim that the newest European snake oil will cure the ailments of Europe for all time, for forever and for always. Yes, well, the printing of money has a cost besides the paper and brandishing yourself as the next new Savior of Europe is the trick of Kings and countless empires on the Continent and yet here we are after being saved so many times in the past. So I will tell you this; you produce the Vampire and then I will buy the garlic and we’ll leave it at that!
There has been much confusion over last week's remarks by Mario Draghi, with the prevailing narrative being that the market first got what Draghi meant wrong (when it plunged), then right (when it soared). The confusion is further granulated by attempts to explain what was merely a desperate attempt at delaying a decision for action, which was inevitable considering the now open opposition by Buba's Weidmann, into a formal and planned plotline: "Inverse Twist" or other such technical jargon is what we have seen floating around. The reality is that, just like all other central bankers, Draghi did what he does best: use big words and threats of action in hope it will buy him a few extra days of time. The reality is also that, just like when the LTRO was announced, the market did get it right initially, when peripheral bonds plunged, and got it wrong over the subsequent 3 months when bond prices rose, only to collapse to new lows (and in the case of Spain - record high yields as of two weeks ago). Back then, the ECB merely bought a few months time with its transitory intervention. This time it has at best bought a few days with the lack of any actual action. And yet, Draghi did leave a way out, for at least another brief respite (where unless Europe expands the available bailout machinery yet again, the respite will have an even briefer half life than that from the LTROs). The way out is simple, and in order to avoid any confusion, we will use an allegory from the movie Batman: Spain and Italy can be saved. But first they must be destroyed.
The short-end of the Spanish curve is collapsing rapidly, and at last check was tighter by nearly 70 bps even with the 10 Year essentially unchanged, for one simple reason: more hope and prayer. This time we have completely unconfirmed and unverified talk that either the ECB will hold another conference, or that Spain will finally request a full blown bailout. Neither is likely to happen, certainly not on a Friday. In other words, the rapid steepening of the curve on more "talking" will not last. What will however, is increasingly negative sentiment toward the longer end of peripheral country bond curves. To wit, here comes JPM recommending a new short position in Spanish 10 Years. Below is the full text of JPM's Gianluca Sanford saying to short the Spanish 10 Year until it touched 7.75%. Why 7.75%? Because that is the level at which Rajoy will have no choice but to demand a bailout. The irony is that the market, by frontrunning politicians, continues to make the required political decision impossible - welcome to the new normal. Paradoxically, only after the market has fully abandoned hope, can the desired outcome happen. But it will take the broken market a few more weeks to figure this out.
Summary of what has been said so far: Nothing, just as we said last week. Draghi basically repeated the June 29 summit bottom line that the EFSF should buy PIIGS bonds, the ECB "May" act, which means Germany is still not on board, and that after talking markets up by 5%, he has delivered nothing but a delay. This is a huge blow to his and the ECB's credibility.
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With speculation ripe out of everyone from Reuters to the FT about what Draghi may or may not say, with or without Germany's blessing, the best at this point is just to hand over the microphone to the former Goldmanite. Here is the live webcast of Draghi's press conference. Pay attention as a word out of place will send the EURUSD plunging by 200 pips. Or soaring.
The European Equities are in positive territory at the North American cross over. The CAC-40 was the initial outperformer following SocGen’s earnings. Despite reporting a drop of more than 40% in Q2 net profits year over year, the co. beat analyst expectations on Q2 CIB net and announced the completion of its cost cutting measures and traded up to highs of EUR18.57, though shares have since pulled back into negative territory. The FTSE-100 now leads the way despite a sharp decline in July’s UK Manufacturing PMI, which came in at 45.5, the lowest reading since May 2009. This saw GBP/USD also tumble to intra-day lows of 1.5619, though the pair has since stabilised around 1.5650. Elsewhere, comments from ECB’s Weidmann that “governments overestimate ECB possibilities”, going against general consensus and speculation that the ECB will announce further stimulus measures at tomorrow’s meeting, provoked a sharp drop in the riskier assets and the Bund to gain 8 ticks, though as it came to light that these comments were taken from an article published on June 29th, the move was pared.
While in principle central banks around the world can talk up the market to infinity or until the last short has covered without ever committing to any action (obviously at some point long before that reality will take over and the fact that revenues and earnings are collapsing as stock prices are soaring will finally be grasped by every marginal buyer, but that is irrelevant for this thought experiment) the reality is that absent more unsterilized reserves entering the cash starved banking system, whose earnings absent such accounting gimmicks as loan loss reserve release and DVA, are the worst they have been in years, the banks will wither and die. Recall that the $1.6 trillion or so in excess reserves are currently used by banks mostly as window dressing to cover up capital deficiencies masked in the form of asset purchases, subsequently repoed out. Which is why central banks would certainly prefer to just talk the talk (ref: Draghi et al), private banks demand that they actually walk the walk, and the sooner the better. One such bank, which has the largest legacy liabilities and non-performing loans courtesy of its idiotic purchase of that epic housing scam factory Countrywide, is Bank of America. Which is why it is not at all surprising that just that bank has come out with a report titled "Shipwrecked" in which it says that not only will (or maybe should is the right word) launch QE3 immediately, but the QE will be bigger than expected, but as warned elsewhere, will be "much less effective than QE1/QE2, both in terms of boosting risky assets and stimulating the economy."
"This market isn't real. The two percent on the ten-year, the ninety basis points on the five-year, thirty basis points on a one-year – those are medicated, pegged rates created by the Fed and which fast-money traders trade against as long as they are confident the Fed can keep the whole market rigged. Nobody in their right mind wants to own the ten-year bond at a two percent interest rate. But they're doing it because they can borrow overnight money for free, ten basis points, put it on repo, collect 190 basis points a spread, and laugh all the way to the bank. And they will keep laughing all the way to the bank on Wall Street until they lose confidence in the Fed's ability to keep the yield curve pegged where it is today. If the bond ever starts falling in price, they unwind the carry trade. Then you get a message, "Do not pass go." Sell your bonds, unwind your overnight debt, your repo positions. And the system then begins to contract... The Fed has destroyed the money market. It has destroyed the capital markets. They have something that you can see on the screen called an "interest rate." That isn't a market price of money or a market price of five-year debt capital. That is an administered price that the Fed has set and that every trader watches by the minute to make sure that he's still in a positive spread. And you can't have capitalism if the capital markets are dead, if the capital markets are simply a branch office – branch casino – of the central bank. That's essentially what we have today."