Sovereigns

The importance of the negative credit outlook from Moody’s lies less in the realm of financial markets, given how little investors seem to value the views of the credit rating agencies. Rather the major importance lies in the policy and political reactions to the rating actions. As UBS notes, there is a risk of popular (not political leadership) adverse reaction. The media in Germany (where there is a tradition of media hostility to the Euro periphery) or in the Netherlands (approaching a general election in September) may portray this as "we are being dragged down by the Euro periphery". If that does transpire it could easily fan the flames of populist resentment of the Euro still further. Critically, if the media attribute (or mis-attribute) the blame to the periphery, there could be obstacles to that integrationist momentum. The reality of a common monetary policy and the necessity of some kind of communalized fiscal responsibility are being brought to bear on the Euro area polity - but markets seem confused. CDS markets are pricing Germany's risk as if it was becoming increasingly encumbered to the periphery and yet the FX market is dragging EURUSD lower on expectations of massive upheaval and potential SPexit with no German 'unlimited' support. CDS appears to fit with raters, FX more with haters - or as UBS points out, perhaps all is not well in Germany as it "has demonstrably failed to grow its way out of debt."

Just as the summer finally arrives in Northern Europe, the Eurozone crisis is heating up once again. With an increasingly flat (heading to inversion) yield curve, and spreads at record wides,  Spain appears to be in a downward spiral of market turmoil that might require a full-fledged TROIKA bail out. However, as UBS points out, rather than taking the country off the market, the program would have to allow Spain to keep borrowing from private investors. Any bail out of Spain would have to be designed in a way that would also be applicable to Italy. Spain has been the most recent crisis focus, and looks to intensify further with nothing immediately in sight that could reverse the trend. We, like UBS, have argued for some time that a full-fledged TROIKA program will ultimately be unavoidable and the following six reasons briefly explain why anything else is a pipe-dream - as we remember Draghi's recent shift: "creditors should be part of the solution of the crisis. It is a matter of limiting the involvement of taxpayers. They have already paid a great deal."

In a first for Moody's, the rating agency, traditionally about a month after Egan Jones (whose rationale and burdensharing text was virtually copied by Moody's: here and here), has decided to cut Europe's untouchable core, while still at Aaa, to Outlook negative, in the process implicitly downgrading Germany, Netherlands and Luxembourg, and putting them in line with Austria and France which have been on a negative outlook since February 13, 2012.The only good news goes to Finland, whose outlook is kept at stable for one simple reason: the country's attempts to collateralize its European bailout exposure, a move which will now be copied by all the suddenly more precarious core European countries.

Russia and the southeast Asian countries are analogs for Greece, Spain, and Cyprus, with no particular association between their references within the timeline.  The timeline runs through the Russian pain; things begin to turn around after the timeline ends. This is meant to serve as a reference point: In retrospect it was clear throughout the late-90s that Russia would default on its debt and spark financial pandemonium, yet there were cheers at many of the fake-out "solution" pivot points.  The Russian issues were structural and therefore immune to halfhearted solutions--the Euro Crisis is no different.  This timeline analog serves as a guide to illustrate to what extent world leaders can delay the inevitable and just how significant "black swan event" probabilities are in times of structural crisis.  It seems that the next step in the unfolding Euro Crisis is for sovereigns to begin to default on their loan payments.  To that effect, Greece must pay its next round of bond redemptions on August 20, and over the weekend the IMF stated that they are suspending Greece's future aid tranches due to lack of reform.  August 20 might be the most important day of the entire summer and very well could turn into the credit event that breaks the camel's back.

Too Big Leads To Destruction of the Rule of Law

It has been a tempestuous week where good is bad, worse is better, but European news is to be sold. Here is your one stop summary of all the notable bullish and bearish events in the past seven days.

Economists, Military Strategists and Others Warned Us … Long Ago

You may recall that the PSI (Private Sector Involvement) was a one-off event as heralded again and again in the Press by every political leader in the European Union. This proclamation was thundered from the rafters, held up like a banner by the ECB and trumpeted by every Parliament in Europe. The message was clear and rolled out like a red carpet for bond owners, “This will never happen again.” Amazingly, or perhaps not so, is the length of time that “never happen again” took to dissipate. The European Union and the European Central Bank are now signaling a change of position as tax payers always trump the owners of bonds and I fear one more example of this is about to be shoved down our throats. Mr. Draghi’s recent statements are all but a fait accompli in my opinion and you may expect some definitive announcements very soon. The situation is even more grave than this however as the question of “seniority,” already a distressing issue, is also going to be re-addressed and I think recalculated in some very non-conventional ways so that an owner of senior debt in European sovereigns and European banks will find himself behind an eight ball with absolutely no control and in serious jeopardy.

Ben Bernanke will deliver the semiannual report on monetary policy to the Senate Banking Committee Tuesday. The market is hoping and praying that the Chairsatan will make it rain. He won't. In fact, as explained earlier, it is likely that Ben will say absolutely nothing of significance today and in a world in which only the H.4.1 matters, this is not going to be taken well by the market. Of course, if Benny does crack and promises to push the S&P to 1450 just in time for the re-election, all bets are off.

In the US and Europe we have slowly come to the realization that traditional accommodative economic policies leave, and have left, the real economy limp.  Wildly divided governments don't help, but beyond the fact that western decision making bodies are polarized, it is abundantly clear that the panacea for the global economy is not even on the table right now.  The western world has been thrown into a bout of sovereign game theory, and by the constructs of game theory itself, one country will "win," while everyone else will lose to varying degrees.  But that we are such a highly integrated global economy--the reason the whole world is heading towards recession right now--means that a solution must incorporate every economy around the world.  The current game Europe is playing is bound to fail because if one country gets their way, others lose by definition.

Two of the three major credit ratings agencies have recently affirmed their outlook on the US sovereign credit rating, but all three continue to hold a negative outlook on the rating. In Goldman's view there is little likelihood that additional ratings actions will be taken this year, but the possibility of a ratings change is another risk posed by the "fiscal cliff," debt limit, and related debate over medium-term fiscal reforms that looks likely in 2013. All three rating agencies look likely to reassess the rating over the next year or so. In light of the recent announcements and upcoming fiscal events that could influence the rating, Goldman Sachs Economics team provides some updated thoughts on the intersection of fiscal policy and the US sovereign rating, in Q&A form.

The decision to downgrade Italy's rating reflects the following key factors:

1. Italy is more likely to experience a further sharp increase in its funding costs or the loss of market access than at the time of our rating action five months ago due to increasingly fragile market confidence, contagion risk emanating from Greece and Spain and signs of an eroding non-domestic investor base. The risk of a Greek exit from the euro has risen, the Spanish banking system will experience greater credit losses than anticipated, and Spain's own funding challenges are greater than previously recognized.

2. Italy's near-term economic outlook has deteriorated, as manifest in both weaker growth and higher unemployment, which creates risk of failure to meet fiscal consolidation targets. Failure to meet fiscal targets in turn could weaken market confidence further, raising the risk of a sudden stop in market funding.

It seems every week there are new acronyms or catchy-phrases for Europe's Rescue and Fiscal Progress decisions. Goldman Sachs provides a quick primer on everything from ELA to EFSM and from Two-Pack (not Tupac) to the Four Presidents' Report.

European equity indices are plunged today - extending the losses from the US yesterday - with Spain and Italy underperforming. Spain's IBEX is now -1.4% from pre-EU Summit levels though the rest are all green still (with Italy's MIB lowest of the rest at +1.5%). However, it seems that broad European stocks are finally catching-down to the dismal weakness in European credit (both financials and corporates) since the EU Summit. Europe's sovereign bond spreads all leaked wider on the day (be careful with yields since the benchmark 'safe havens' are so bid right now thanks to the flood of deposits into the front-end of German, Swiss, Dutch, and Austrian repo-able instruments). Spain and Italy remain wider than pre-EU-Summit levels (marginally) - though today saw the CDS-cash basis (as we noted in the pre-European open was likely) compress on these as Spain's 5Y CDS tests 575bps again. EURUSD broke 1.22 - new two-year lows - and is closing the Europe session below that level but the EUR crosses are all heading towards record lows (interestingly watching EURJPY as chatter is a rotation from JPY to EUR as a funding currency). German 2Y joined Swiss 2Y in the NIRP world as we note that the Swiss curve us now negative out to 5Y once again.

Because I pay attention to these things; I have the sense that there has been a lot of praying recently. Prayers for QE3, prayers for Quantitative Easing mortgage bond buying, “Please SIR;” and for words to the effect in each and every FOMC minutes that “Money will be printed forever and ever Amen.”

“Now I know I'm not normally a praying man, but if you're up there, please save me, Superman!”

                          -Homer Simpson

Now I hate to do this to you and I feel like the bad boy with the pin about to prick someone’s bubble but these prayers have gone unanswered as you know and are not likely to be answered any day soon unless Europe goes up in pixie dust which, while certainly possible, will be far more serious for the markets and will more than offset the Fed dragging out their printing presses and plugging them in once again.