Sovereign Debt

There has been much speculation about how the Greek endgame will play out, but precious little from the perspective of Germany. Until today. Courtesy of a three part series from Handeslblatt (here, here and here) we now know precisely what the next steps are as visualized by Europe's piggybank, which now is telegraphing it is set to cut Europe's most wayward child loose.

THIS is the fate that awaits the European banking system. Every single EU bank has leveraged itself based on financial models that consider sovereign bonds to be “risk free.” Moreover, EVERY EU bank is leverage to the hilt based on its OWN in-­?house assessment of the riskiness of its loan portfolio.

We are in the last innings of a very bad ball game. We are coping with the crash of a 30-year–long debt super-cycle and the aftermath of an unsustainable bubble. Quantitative easing is making it worse by facilitating more public-sector borrowing and preventing debt liquidation in the private sector—both erroneous steps in my view. The federal government is not getting its financial house in order. We are on the edge of a crisis in the bond markets. It has already happened in Europe and will be coming to our neighborhood soon. The Fed is destroying the capital market by pegging and manipulating the price of money and debt capital. Interest rates signal nothing anymore because they are zero. Capital markets are at the heart of capitalism and they are not working.

European equity markets are seen trading in negative territory across the board at the midway point as the lack of a Greek governing coalition continues to weigh on sentiment. As such, an earlier Greek T-Bill auction passed by with an unsurprising increase in borrowing costs for the country. The concern over sovereign debt is clear elsewhere, as the spread between peripheral 10-year government bond yields remain wider against the German Bund. Very strong German Industrial Production data has failed to provide relief for the DAX index as concerns on the periphery outweigh the strength in the core. The monthly reading for March beat expectations, coming in at 2.8% against estimates of 0.8%. Overnight reports from the Spanish press concerning a government intervention in the lender Bankia have been denied by the Spanish Ministry, commenting that the aim for the company is a cleanup and restructuring, not a seizure. EU’s Almunia has commented on the developments, saying that it seems likely the bank will receive state aid.

The global economy is facing a structural surplus of labor and a scarcity of paid work. Here is the critical backdrop for the global recession that is unfolding and the stated desire of central banks and states everywhere for "economic growth": most of the so-called "growth" since the 2008 global financial meltdown was funded by sovereign debt and "free money" spun by central banks, not organic growth based on rising earned incomes. Take away the speculation dependent on "free money" and the global stimulus dependent on massive quantities of fresh debt, and how much "growth" would be left? The Internet has enabled enormous reductions of labor input. A mere 15 years ago when I first learned HTML (1997), you had to code your own site or learn some fairly sophisticated website creation/management software packages, and you needed to set up a server or pay a host. Now anyone can set up a Blogspot or equivalent blog for free in a few minutes with few (if any) technical skills, and the site is free. The other trend is the cost of labor in the developed West is rising as systemic friction adds cost without adding productivity. Workers in the U.S. only see their wages stagnate, but their employers see total labor costs rising as healthcare costs rise year after year. In effect, the U.S. pays an 8% VAT tax to support a bloated, paperwork-pushing, inefficient and fraud-laced healthcare system that costs twice as much as a percentage of GDP as other advanced democracies. No wonder many entrepreneurs are selling their high-overhead businesses and becoming flexible, low-cost one-person enterprises.

Arguably, more millionaire money was made during the Great Depression than at any time in history. Well, if that's true then it looks as if history may be poised to repeat itself. The question is, who will be ready?

We have said, for months now, that Europe and the United States were heading in two different directions. That became quite clear today as the manufacturing numbers for Europe were dismal while unemployment for the entire Eurozone reached 10.9% which is up 9.1% from last year. The entire Continent is in a recession, with the exception of Germany, and we think their next release, in mid May, will show that they have joined the rest of their brethern. Austerity has its costs and two of them are increased unemployment and a decline in demand for goods and services which is then exacerbated by the drop in the number of people that are working. In the months ahead, for both political and economic reasons, we will see a flight back to American assets as the picture in Europe becomes both clearer and obviously worse. All of this, however, will affect American corporations and our banks so that expectations should be lowered in coming quarters for American earnings and profits. As “no man is an island,” no region of the world will be exempt from the European recession just as Europe was not exempt from our financial crisis.

The question for investors is how likely Draghi unleashes some new money and gives the market another brief relief rally? I’m not sure he is able to do anything meaningful and right now I believe the market will fade over the course of the day as realization sets in that not much can be done. I’m not quite ready to put this trade on, but am looking closely at going long Spanish stocks versus short German stocks. The belief that Germany will be fine while Spain is a disaster seems too common and priced in. I’m not quite there on that trade, but it is only that am looking at very closely.

Simultaneous Global Printing Is Failing Miserably

When we talk about Europe today in an economic context, we really mean the Eurozone, whose seventeen members are the core of Europe and share a common currency, the euro. The euro first came into existence thirteen years ago, on January 1, 1999, replacing national currencies for eleven states; Greece joined two years later. In theory, the idea of a common currency for European nations with common borders is logical, and it was Canadian economist Robert Mundell's work on optimum currency areas that provided much of the theoretical cover. However, the concept was flawed from the start.

Collateral matters when it comes to assessing the value of the debt. If a bank lists the mortgages in its "assets" column at full value even though the underlying collateral (the houses) has lost much of their value, then the bank is grossly over-estimating the value and security of the mortgage. The bank's "assets" are based on phantom collateral. Take away $1 in collateral and you impair $4, $10, $20 or even $30 of debt. Recall that the vast majority of real estate equity and financial wealth is owned by the top 20%, with the majority of that concentrated in the top 5%. That means the bottom 80% own little collateral to leverage into debt. How about leveraging income into more debt? Since the top 10% receive almost 50% of the income, and most of the bottom 90%'s income goes to non-discretionary spending and taxes, then only the top 10% have discretionary income that can be leveraged into more debt.

By definition, we cannot shrink our way back to the sort of growth required to service the West's accumulated debts. Something has to give. That something will ultimately be social and political disorder on a continent-wide basis, particularly as the taxpayer becomes increasingly frustrated in his obligations to fund the rapidly growing and untenable costs of Big Government. Such disorder is almost universally feared-- by politicians, by markets, by institutions. As the London-based marcoeconomic research consultancy Capital Economics recently commented: "The last thing that the markets need right now is increased political uncertainty at the heart of Europe at a time when the economic outlook is already bleak..." The only reasonable response to this is: tough. If social and political disorder is what it takes to shift an unsustainable status quo in which vampire banks and clueless bureaucrats suck the life out of the productive economy, bring it on.

Another day of ugly news out of Europe, with both macroeconomic and monetary data coming in to confirm that downward slope of the European forward trajectory (not to mention funny: below is a chart of Greek retail sales. Hardly any commentary is necessary). Yet despite some recently gravity in the EURUSD, for the time being the futures are trending flat to slightly down, perfectly ambivalent as to how will ease first as long as someone eases. Will this sustain, or will a disappointing Chicago PMI at 9:45 am once again send stocks first plunging then soaring on hope of imminent NEW QE? We will find out shortly. In the meantime, here is a recap of the overnight market action.

Three weeks ago we discussed the ultimate-doomsday presentation of the state of Spain which best summarized the macro-concerns facing the nation and its banks. Since then the market, and now the ratings agencies, have fully digested that meal of dysphoric data and pushed Spanish sovereign and bank bond spreads back to levels seen before the LTRO's short-lived (though self-defeating) munificence transfixed global investors. However, the world moves on and while most are focused directly on yields, spreads, unemployment rates, and loan-delinquency levels, there are two critical new numbers to pay attention to immediately - that we are sure the market will soon learn to appreciate. The first is 5%. This is the haircut increase that ECB collateral will require once all ratings agencies shift to BBB+ or below (meaning massive margin calls and cash needs for the exact banks that are the most exposed and least capable of achieving said liquidity). The second is 10%. This is the level of funded (bank) assets that are financed by the Central Bank and as UBS notes, this is the tipping point beyond which banks are treated differently by the market and have historically required significant equity issuance to return to regular private market funding. With S&P having made the move to BBB+ this week (and Italy already there), and Spain's banking system having reached 11% as of the last ECB announcement (and Italy 7.7%), it would appear we are set for more heat in the European kitchen - especially since Nomura adds that they do not expect any meaningful response from the ECB until things get a lot worse. The world is waking up to the realization that de-linking sovereigns and banks (as opposed to concentrating that systemic risk) is key to stabilizing markets.

The US is now about to enter fully-fledged "election mode". With only two candidates left in the "race" for the Republican nomination - only one according to the mainstream media, but more on that below - the "issues" at stake in the upcoming election are now being very carefully tailored for an increasingly unruly domestic US political audience. A less polite way of phrasing this is that the spin is becoming dizzying. The foremost task of preparing for the November vote is to maintain the illusion that any and all economic or financial "hiccups" which might affect the US in the next six months are not home gown. The US establishment has never fooled all of the people all of the time -just enough of them to keep their power. The problem is that this keeps getting harder to do.