"Lulled To Sleep"

Yesterday, Jens Weidmann called it a "drug addiction"; for the past 4 years we have called it sheer insanity (and other less polite words). Whatever one calls it, it is obvious that using monetary policy to delay the need for real (not theatrical) fiscal policy involvement that sees to restore debt credibility (i.e., deleverage) does nothing to fix the underlying problems, and merely provides an ever briefer respite from the symptoms of insolvency without ever addressing the underlying cause. Today, even Bank of America has realized this fundamental Catch 22 that is now the paradox at the heart of what remains of capital markets: more easing serves to appease politicians, who see no need to change any of their broken policies, in the process requiring even more QE in the future, and so on, until this always ending in tears game of extend and pretend comes to a sudden and violent end.

From Bank of America

The markets are in a strong “risk on” mode. The European crisis seems to be fading and, while tensions around Iran are rising, most experts argue that a military strike is unlikely before the US presidential election. The “fiscal cliff” is not high on the corporate worry list—it is a distant third, behind general concerns about the economy and the European crisis. The VIX measure of stock market volatility is at a five-year low. Perhaps the consensus and markets are right and the economy will hang glide over the fiscal cliff and other concerns.



However, we remain very concerned about the outlook. In our view, the markets have been lulled to sleep by a temporary remission in negative macro news. We believe the Euro zone crisis is far from over. At this stage the policy pattern for Europe is well established: (1) A funding problem in one of the peripheral countries arises; (2) policy makers engage in brinkmanship with the core demanding austerity and the periphery demanding bailout; (3) the markets start to melt down; (4) policy makers do just enough to satisfy the markets, but not cure the underlying problem. What’s more, the worst of the US fiscal crisis also lies ahead. Note that in the uncertainty shock literature,   the impact of the shock grows exponentially as the day of reckoning approaches. The cliff is slowly working its way into corporate thinking. The real test will come in the fourth quarter.


Of course, none of this is new, and the most recent, and far better graphic summary of all of the above, only now needing an extension to all groupings of "serious men", not just those in Europe, came from David Einhorn.