Holy smokes! The EU technocrats have finally pulled out the big guns! The agreement on Friday was to take the incredibly bold step of avoiding subordination in the Spanish bond market. The money needed for the busted Spanish banks will now be made available directly from Brussels with few strings attached. Wow! What a breakthrough!
Global markets have taken a quick look at what has been offered up by the deep thinkers in Euroland and said, “WE LOVE IT!”
Me? I think it’s a spit in the bucket. The half-life of this bailout will be measured in weeks.
We have seen this play out time and again the past four years. The capital markets are forcing policy decisions.
“Wise” people like Paul Krugman have said for years that “Bond Vigilantes” don’t exist. There is no doubt any longer that they exist and are alive, well and hungry. The vigilantes are also armed with highly sophisticated robots that can execute attacks on multiple fronts and across markets in milliseconds. The war going on in the bond markets is not over by a long shot.
My read of the EU summit is that Spanish banks are going to get a “soft” bailout. Existing common shareholders and subordinated bond holders will not get wiped out (as they should). The bankers must love this result. They get to keep their jobs for a few years longer, all the time praying for a miracle.
Where does this go? Directly to Italy. Which Italian bank would love to have some of that cheap equity money that Brussels is doling out? All of them.
But here’s the deal, France’s banks are in desperate need of new equity too. They have been selling off assets left and right. That’s no way to keep up employment in Socialist France. There are some very big balances sheets in Paris that need a new slug of 3% Perpetual Preferreds. If Italy’s banks get the "Sweet Deal," then the French banks will have their hands out too.
Talking about re-caps of banks in Spain, Italy and France, we might just as well include a few dodgy banks in Brussels. A couple of German banks are also thin on equity. Add a few of them to the list.
Ah… I’m sorry to rain on the parade, but the number derived from all that bailing starts with Euro 1 Trillion, and could easily push to E2T.
Where is this big sum of money coming from? A three-letter entity that doesn’t really exist yet? One whose charter requires votes from EU countries? The “savior” that is going to do the trillions of bank-bailing actually doesn’t have a penny to its name.
And can I ask someone about the timing of all these things getting sorted out? Look at the calendar. Europe is on holiday. See you in September before any of this is inked and the money is flowing. The vigilantes are not on Vaca.
If I'm right, after a few weeks things turn south again in the capital markets. Then what?
- More LTRO. No – there is no more collateral. All of the swill loans have already been hocked.
- Cut ECB % rate. Doesn’t matter. It won't change conditions in Italian or Spanish funding markets one bit.
- A spending plan of <1% of GDP. That won’t put a dent in the recession that is building.
- Brussels buys more sovereign bonds to avoid a catastrophe of Italian 10-year exceeding 7% (capitulation). Sorry. There are “wise men” in Germany who will simply not allow this to happen in the scale that is required.
- The ECB goes Defcon 1 and launches a E2T QE program. No – same answer as above.
- Merkel does a 180 and embraces Euro bonds. No chance in hell.
-The US or China are going to start buying EU bonds? Lunacy – not happening.
-The IMF will come to the rescue? No way – the IMF does not have the resources to solve anyone’s problems.
There are more bullshit things that could be added to this list, but they either will not work, or are too politically unacceptable to happen. If the steps taken on Friday fail to stem the crisis beyond a few weeks, what else is on the table for consideration? The answer is that whatever may be coming, it must meet the following criteria:
-must be able to be implemented in a very short period of time (e.g. a Sunday night announcement).
-must have a global component. Europe does not have the resources to address the problems it faces alone.
-can’t be subject to political approval. That process takes too long, and the politicians can’t agree on anything of substance.
What policy steps meet these requirements? There is only one. The next significant step out of Europe will involve changes in FX rates around the globe. A number of possible currency steps have already been discussed, including:
1) Peripheral countries re-establish their legacy currencies. Spain will reintroduce the Peseta, Italy will bring back the Lira etc.
2) The Euro is split in two. There would be a Northern and a Southern Euro.
3) Germany leaves the Euro and re-establishes the Deutche Mark.
These are possible outcomes. But I consider them to be unlikely. Too much effort has been taken to create and preserve the Euro for the deciders to throw in the towel anytime soon.
There is one currency option left. Devalue the Euro by 20++%.
This would make a difference. It would go a long way towards stabilizing the real economies of Europe. It would create inflation, something that is sorely needed to devalue the real size of Europe’s debts. Germany would agree to this as it preserves their export-competitive position within the EU, and improves it outside of the EU. The technocrats in Brussels would love it; it’s the only thing left that would preserve the monetary union.
Is this feasible? I say it is. It has happened twice before in history. In 1985 the world got the Plaza Accord that devalued the dollar and in 1987 we got the Louvre Accord that revalued the dollar. In both cases, the global central banks (CBs) and acted together.
With Plaza Accord, the CBs made a joint announcement on a Sunday evening that they would be selling the dollar against major currencies until such time as a meaningful devaluation had been achieved. It worked.
A devaluation of the Euro (versus the Yen, Sterling and the Dollar) would be approved in Brussels in a heartbeat. Germany would be reluctant because of the inflationary implications, but it would reap the benefits of a cheaper currency too. The USA and China would absolutely hate to see a devaluation of the Euro. It would hurt their respective economies. But the deciders in China and Washington also know that a complete breakdown of the EU economy would lead to a global depression.
The timing of something like this is critical. Would Obama instruct the Treasury Department to intervene in the currency markets (via the Federal Reserve)? He would, if it happened in the next few months. The consequences would not be felt, in a meaningful way, by US exporters until after the November election. Obama also understands that if the EU goes belly up before the election, his chance of winning goes down. If the EU tanks, so will the S&P.
China and Japan would have some say in this in order for it to be successful. The CB interventions would have to be coordinated. If the UK and US go along with it, then Japan will be forced to join in.
China is a wild card. If China participated, it would be devaluing its own Euro reserves. It would cost China a few hundred billion dollars. But it would cost China far more if the EU went into the crapper for the next five years.
I’ve been out of the FX markets lately. I’ve been concerned about “event risk”, where something is accomplished in Europe that actually made a difference. I think that this kind of event risk is now behind us. I bought some puts on the Euro Friday afternoon. We shall see.
The idea of a coordinated central bank response ala the Plaza and Louvre Accords may seem far-fetched. But tell me another option that has a chance of working.
What is the “fair” value of the Euro? Whatever the central banks want it to be. Is the Euro over valued today? Visit the EU and make your own judgment. I say it is. The following articles go a long way towards answering the question of the Euro’s value versus the dollar. When EADs puts up $600m to build a manufacturing facility in Mobile Al., you know the Euro is over-valued.
Given what is happening in Europe these days, I'm surprised that Airbus is doing this. Places like Spain could use the $600m investment in plant, equipment and jobs that goes with this. Good for Mobile, not so good for Europe.