Germany

Perfidy—as Target 2 balances balloon and risks spiral out of control

It appears that after months of abuse for their water-is-wet economic insights, the San Francisco Fed may have stumbled on to the cold harsh reality that this post-great-recession world finds itself in. The crux of the matter, that will come as no surprise to any of our readers, is credit and "its central role to understanding the business cycle". Oscar Jorda then concludes, in a refreshingly honest and shocking manner that "Any forecast that assumes the recovery from the Great Recession will resemble previous post-World War II recoveries runs the risk of overstating future economic growth, lending activity, interest rates, investment, and inflation." His analysis, which Minsky-ites (and Reinhart and Rogoff) will appreciate - and perhaps our neo-classical brethren will embrace - is that the Great Recession upended the paradigm that modern macro-economic models omitted banks and finance and this time it really is different in that the 'achilles heel' of economic modeling - credit - cannot be considered a secondary effect. His analysis points to considerably slower GDP growth and lower inflation expectations as he compares the current 'recovery' to post-WWII recoveries across 14 advanced economies - a sad picture is painted as he notes "Today employment is about 10% and investment 30% below where they were on average at similar points after other postwar recessions."

The bailout gravy train is slowing and possibly even stopping right at the time when Spain (a REAL problem) is going to start looking for a bailout. So what do you think happens when the ECB chooses to print more and Germany threatens to pull out the Euro… OR the ECB tells Spain it can’t provide any additional funds?

Investing in an uncompetitive company in the ugly EU auto market to bail out its own failing subsidiary.

As reported last week, and as shown brilliantly by Artemis Capital, the end of every reliquification phase by the Fed, such as the imminent end of Operation Twist with nothing firmly set to replace it, is always accompanied by a surge in vol, which in turn leads to market days like the past week, when market summaries are simple: either it is all Risk On, or Risk Off. Expect many more of these until Twist finally ends in just over two months at which point much more liquidity will be needed to achieve the same "flow" results. It just so happens that today is a risk On day, driven by previously noted "catalyst." Yet what is great about such days is that they allow all the bad news to be packed into a tidy little package and disseminated without anyone noticing, or pretending to notice. Such as the just announced headline from Reuters, which on any other day would have crippled the mood, that "Italy will delay by a year its current plan to balance its budget in 2013, according to a draft forecasting document to be approved by the cabinet on Wednesday." And while we have seen this over and over in the past 2 years, first with Greece, then with all the other PIIGS, it merely exposes the fact that exuberant optimism never pans out in a world in which the real average debt/GDP is what Reinhart and Rogoff would simply call "unsustainable." And while this news will matter once Germany realizes that its precious fiscal pact is already been soundly rejected, first by Spain and now Italy, for now it is but a footnote in the otherwise lacking newsflow: after all Spain managed to issue €2 billion in Bills, which contrary to yesterday, provides that all is again well in Europe. Until Thursday at least when Spain has to issue 10 year bonds, which just happen to mature outside of the LTRO. The narrative then may be somewhat different.

Today's futures pop on short-term bill auctions in Europe (that remain in a world of their own and should not be considered as anything but emergent in nature rather than indicative of investor demand) and ad hoc data in Germany that disconnects from any sense of reality in true economic environs only confirms Morgan Stanley's Mike Wilson's perspective that there still isn't much fear out there. We remain in the midst of a longer-term deleveraging cycle, of that there can be little argument in reality (unless of course exponential trends are natural) and as Wilson points out we are likely to remain in the wide trading range that we have been in the past two years - however, many investors appear to disagree (not the least of which the effusively exuberant 'Ace' Greenberg this morning). Few expect a correction more than 5-10%, Buy-lists are already in great demand, and put-call ratios remain muted. "Of course, this is what happens when an animal becomes conditioned to buy the dip in a pavlovian manner over years during which they have remain unscathed by some of the biggest financial risks we have ever witnessed. As the saying goes, “the only fools bigger than those that are playing are those that are watching.” Of course, having some Fed official speaking every other day to remind us they are there to save the day in the event of trouble helps perpetuate this unnatural one way market." However, his bottom line is that slowing/disappointing economic data, zero percent earnings growth and a liquidity lull sounds like a recipe for more than a 5% correction.

European markets are seen trading higher as North America comes to market, with some momentum seen following the release of the forecast-beating German ZEW Survey. An economist from the institution commented that downside risks have decreased significantly over the past month, prompting some risk-appetite in Europe during the morning. Participants were also looking towards the Spanish T-Bill auction with particular focus, but it did not confirm the nation’s worst fears as the auction passed with strong bid/covers, selling to the top of the indicative range. Yields, however, did increase over both lines. As such, the Spanish 10-yr yield has fallen below the key 6% mark and remained below that level for most of the session. Peripheral 10-yr spreads against the German Bund are seen tighter throughout the day, amid some market talk early in the session of domestic accounts buying the paper, however this remains unconfirmed.

When it comes to sovereign bond issuance out of Europe the market either continues to be blissfully ignorant or is purposefully stupid: a few hours ago Spain sold €3.18 billion in 12 and 18 month bills, which was more than the expected €3 billion, and which, while coming at higher rates than before, set off a futures buying spark. What however has been pointed out over and over is that issuance of Bills that come due (by definition) within the LTRO's 3 year maturity is meaningless: all it does is concentrate and front-load maturity risk. After all what happens if and when the ECB were to ever not roll the LTRO forward? As such, the only true Spanish bond issuance test this week comes on Thursday when the country issues 10 year bonds. Everything else is merely designed to take advantage of a headline driven market. Specifically, Spain issued €2.09 billion in 364-day bills, which priced at an average yield of 2.623% vs 1.418% at auction on March 20, and at a 2.90 Bid to Cover compared to 2.14 previous. The yield on the second tranche, or €1.086 billion in 546-Day bills soared from 1.711% on March 20 to 3.11% as the Spanish curve again flattens, and despite the rise in Bid to Cover from 3.92 to 3.77, the internals were largely meaningless. Once again, when it comes to true paper demand, the only ones that matter are those that mature outside of the LTRO's 3 years. However today this sleight of hand has worked, and the Spanish 10 year is again under 6.00%, if only for a few hours, sending equity futures higher across the board. Elsewhere, proving once again that no other indicator is better at ramping up stocks, is the coincident indicator known as confidence, German Zew for April came in at 40.7 in April, much higher than expectations of 35, on what however we don't know: dropping markets, soaring inflation, or a return to a declining trendline. Even BofA noted that "There seems to be some disconnect between the latest releases of "hard data" (industrial production, orders received) and the investors expectations." Finally, the Royal Bank of India surprisingly cut its rate from 8.5% to 8.0%, as at least one country can not wait for Bernanke to do his sworn duty of CTRL-P'ing. Oh, and Japan, which has 1 qudrillion Yen in debt, promised to give the IMF $60 billion. So when Japan needs a bail out, we now know that Argentina will step up.

Aiming to Get Votes, Hitting Germany, and Threatening the Euro....

On a long enough timeline, all things come to an end. Even for such venerable venues as the London Metals Exchange, with its 130 year history, and its annual turnover of over $11 trillion in metal contracts, which also makes it the largest market for non-ferrous metals. As the English FT reminisces, "When the LME was established in 1877, Britain was one of the world’s most important manufacturing powerhouses, and the LME’s benchmark contracts for delivery in three months were designed to mirror the length of time needed to reach British ports for shipments of copper from Chile and tin from Malaysia." Furthermore, in the beginning, and all the way through 1993, the flagship copper contract was denominated in sterling, at which point it was switched to the USD following the "Black Wednesday" ERM sterling crisis, courtesy of George Soros who made about $1 billion by shorting the GBP, and formally ended the sterling's role as even an informal backup reserve currency. As of today, insult follows inury, as the LME has formally asked the members of the exchange to drop the sterling contract denomination (in addition to USD, EUR, and JPY contracts) and replace it with the Chinese renminbi. Why this sudden and dramatic, if gradual and tacit, admission that the CNY is the ascendent reserve currency? Because, as the FT reminds us, China has become the market for non-ferrous metals: it is "the dominant force in the market, accounting for more than 40 per cent of global demand for most metals and a rapidly increasing share of trading in LME futures." Add that to yesterday's news of a widening in the CNY band (which incidentally is much ado about nothing, at least for now: at best it will allow China to devalue its currency when and if it so desires much faster than before, much to Geithner's final humiliation), and to the previously reported extensive network of bilateral CNY-based trade agreements already kris-crossing Asia, and one can see why if America is not worried about the reserve status of the dollar, it damn well should be.

Back in October, there were those who were confused how it was possible that European sovereign bond yields could be exploding to their highest in a decade, even as the EURUSD keep grinding higher. We explained it, and said to prepare for much worse down the road. Sure enough, much worse came, and was promptly forestalled as both the Fed expanded its swap lines and lower the OIS swap rate, and the ECB "begrudgingly" ceded to LTRO 1+2 (that this resulted in nominal price gains was to be expected - after all humans enjoy being fooled when price levels rise when in reality just the underlying monetary base has expanded). But how did the EURUSD spike fit into all this? Simple - FX repatriation. This was explained as follows: "the sole reason for the EUR (and hence S&P and global 100% correlated equity risk) surge in the past 9 days is not driven by any latent "optimism" that Europe will fix itself, but simply due to the previously discussed wholesale asset liquidations (as none other than the FT already noted), which on the margin are explicitly EUR positive due to FX repatriation, courtesy of the post-sale conversion of USDs to EURs. Which means that the ever so gullible equity market has just experienced one of the biggest headfakes in history, and has misinterpreted a pervasive European, though mostly French, scramble to procure liquidity at any cost by dumping various USD-denominated assets, as a risk on signal!" It appears we are now back into liquidation mode, and the higher Euro spread surge, the faster EURUSD will rise as more and more FX is "repatriated." In other words, as back in the fall of 2011, the faster the EURUSD rises, the worstr the true liquidity situation in Europe becomes: a critical regime change, which will naturally fool the algos who assume every spike up in EURUSD is indicative of Risk On, and send ES higher when in reality, the underlying situation is diametrically opposite.

When one thinks PIIGS, one usually imagines countries with collapsing economies, 50%+ youth unemployment, and current account deficits so large they are about to drag down the ECB, Bundesbank and Germany. And while that is absolutely correct for the most part, there is one product which the PIIGS, or in this case Italy, are all too happy to export in size. Gold, and not just to anywhere, but to that ultimate safe haven - Switzerland. From BBC: "Italian exports of gold ingots to Switzerland have soared in recent months, data has shown. Exports to Switzerland were 35.6% higher than in February 2011 "mainly because of sales of non-monetary raw gold", statistics agency Istat said. This followed a 34.6% year-on-year rise in exports to Switzerland in January." And the absolutely funniest attempt at spin ever:  "Experts say improvements in the trade deficit could be a sign that Prime Minister Mario Monti's economic reforms are starting to take effect." Uhm, when the country is exporting the only real asset it has for when it will need to backstop its own currency following the inevitable collapse of the EUR, this is not exactly a sign that the country's reforms are taking effect, but rather that everyone else in Europe is stockpiling the precious metal in advance of "some" event, which is coming.

Each day then that passes, as the cash river runs dry, will change the dynamics of the investment world. The biggest change that I see forthcoming on the landscape, beyond those which I have noted, I believe will take place in Germany. China is heading towards some sort of landing and most of Europe is now officially in a recession. The bite of the austerity measures will deepen the process and between the two I think we will begin to see a decline in the finances of Germany which will bring all manner of howls and screams. Germany cannot keep heading in one direction while the rest of its partners founder all around them. The demands of Berlin are self-defeating eventually as demand falls off and I think we are just at the cusp of deterioration in Germany. The problem, all along, has been that Eurobonds or other measures representing a transfer union will cause the averaging of all of the economies in Europe so that the periphery countries benefit with a higher standard of living while the wealthier nations have standards of living that decline as the result of accumulated debts for the troubled nations. This will bring out nationalism again in force as the grand dream succumbs to the grim reality of the costs for nations that have lived beyond their means. The Pied Piper always gets paid and Hamelin still rests upon German soil.
 

The question most asked by clients is why, with all that is going on in Europe, is the currency not much lower as nearly every analysts has a target of between parity and 1.2000? It is a very good question but way back at the start of 2011 I suggested that I felt some accord had been reached by the G20 to hold the EUR stable and this I still believe. The issue is that the EU leadership and indeed all those that trade with the zone, realize that equity markets would be held up by QE and that bond yields could be kept down (wrong) using the same method but the whole house of cards could be brought down if there was a run on the currency and a general loss of confidence in the currency. It would simply be a disaster and to me it is central bank manipulation that is keeping the EUR so ridiculously strong so selling breaks to the downside has seen many karted out on a stretcher and sent to the asylum.

At least that is the bogey according to JPMorgan's Pawan Wadhwa, who in a note announced that the ECB may resume SMP purchases if the 10 year hits 6.5% (as in a few hours), much to the chagrin of Germany, which was foosed into believing LTRO 1+2 would mean no more SMP purchases. More importantly, since the 6.50% barrier will be taken down with impunity in days if not hours, and the SMP has proven time and again to be powerless to prevent mass selling, the next big bogey is 7.50% at which the ECB will likely announce another 3-year Discount Window bazooka, pardon, LTRO. What JPM does not say is that with the halflife of each successive LTRO getting cut in half, LTRO 4 will be needed in June, LTRO 5 in July, LTRO 6 in July, LTRO 7 in July and so on. Most importantly, now that banks, who are desperate for some cash infusion from either the Fed or the ECB, know what the critical threshold bogey for action is, they will be sure to facilitate the ECB's life, and send Spanish 10 Years plunging to at least 7.50% and demand Draghi play ball, again. In other words: now that the market knows what the consensus is to get more European QE, it will promptly do it. After all the LTRO was never for the benefit of the countries: it was always and only to benefit Europe's insolvent banks. If that means "Greecing" Spain in the process, so be it.