"Joan Desborough (ready for a dive); Starlight Park, the Bronx"
Ilargi: Amidst another entire slew of bad news in the markets, the claim to fame for story of the day must go to French bank Société Générale, and the over 22% drop in share price it had at a certain point today - though it was pushed up back to (only?!)-14%-, and the persistent rumors of major trouble and even a potential bankruptcy that have been making the rounds for a few days now. President Sarkozy cut short his holidays to address the situation (other French banks joined the plunge, and France itself may be downgraded).
The best part of it all, however, if you ask me, was this from Bloomberg:
Société Générale "categorically denies all market rumors," Emmanuelle Renaudat, a spokeswoman for the French bank said in an interview. She declined to be more specific.
Well, hey, Emmanuelle, sorry I asked... But wouldn't you want to know what rumors you're denying exactly, before denying them? This is going to sound to a lot of people like you're admitting your company is in trouble. Just saying...
Wall Street, and its banks in particular, once again and still, have their own rumors to deal with. And most of all, they now have to deal with encroaching fear. A fear that is starting to look like it might be very hard to shake.
The Dow closed down 520 points today. 520, or 4.63%! Citi, Bank of America and Goldman Sachs all lost over 10%. It's like we've shifted into a whole new mindset. And Stoneleigh explains why that is:
Stoneleigh: The nature of markets has long been a major focus here at The Automatic Earth. Whereas most commentators treat markets as being driven in some kind of rational fashion by external events, we have concentrated on the irrational endogenous dynamics and the role of sentiment in creating the perceptions that drive positive feedback loops - either virtuous or vicious circles. Sentiment, and therefore perception, can change very abruptly, with far-reaching effects. The events of this past week or so have been a prime example.
The rally of the past two and a half years continued longer than we had anticipated, but on balance of probabilities it is now over, and we are entering the next phase of the credit crunch - the period where a majority begins to appreciate what a credit crunch really means. The first phase, from October 2007 to March 2009, was little more than a mild introduction for many, although even that was enough to push a large number of casualties silently over the edge.
With the dramatic end to the rally (and a loss of over $7.8 trillion in mere days) comes the end of the complacency it engendered. Fear is in the ascendancy once again, and fear is extremely catching. We are already seeing it spread like wildfire and begin to feed upon itself, creating self-fulfilling prophecies. The fundamentals have not changed materially, but the perception of them has, and that is the game changer.
When markets are rising, thanks to optimism and hope, people develop a false sense of predictability, as if events were somehow proceeding as they were meant to, and that they should, by rights, continue to do so. Under such circumstances, market volatility is typically low. In contrast, when markets decline, as fear tightens its grip, that comforting sense of pseudo-certainty evaporates very quickly. Fear breeds extreme volatility as investors try to second guess rapidly unfolding moves, and also each other. The best measure of this volatility is the VIX index.
Initially investors look to buy the dips, on the assumption, born of three decades of expansion, that every decline represents a buying opportunity. Later that assumption will falter, and then fail, but residual optimism takes time to dissipate completely. Every temporary upswing all the way down will rekindle echoes of it. The only relative safety is to be found on the sidelines in cash. While there is money in volatility for some aggressive (and lucky, or well-connected) traders, there will be far more opportunities to lose a fortune than to make one for those who cannot stop playing the game.
Going forward, we can expect more of the stomach-churning market declines we have seen over the past week, but also apparently rocket-fueled, yet short-lived rallies. The sharpest and largest upswings happen in bear markets, interspersed with cascading movements to the downside.
We advise our readers to proceed with great caution and to ignore rationalizations and spurious causation discussed in the mainstream media. In extrapolating past trends forward, failing to anticipate discontinuities, and propagating the smoke-and-mirrors posturing of central authorities desperate to obscure what is happening for as long as possible, they will be arriving at completely incorrect conclusions as to the financial consequences we are facing and what actions we may be able to take in order to protect ourselves. They will also be unhelpfully fanning the flames of fear.
Global commentators have focused recently on the pure political theatre of the rise in the debt ceiling in the US, and subsequently on the downgrade of the US by a single credit-rating agency, but these events do not presage what mainstream opinion has suggested at all. Quite the opposite in fact.
The debt ceiling debate was merely a staged game of brinkmanship, softening up the US population for austerity measures and coming cuts in entitlement programmes targeting the weakest members of society. Imminent default was never a risk. The real risk is the acceleration of the wealth and power grab that has been going on under the guise of quantitative easing for the duration of the rally.
The coverage of the ratings downgrade likewise obscures the real threat. Commentators boldly assert that the US will inevitably have to pay more to borrow, that treasuries are increasingly risky, that the US dollar is doomed and that inflation is an imminent threat. The Automatic Earth has long held diametrically opposed opinions with respect to the next few years, and those are already being vindicated by events.
Our position has long been that the US will benefit from a flight to safety as the least worst option, initially at Europe's expense. Money will flood from where the fear is to where the fear is not, and one look at bond rates and credit default swap spreads is all it takes to see that the fear is concentrated in Europe, while the US is seen as a safe haven.
When fear rules, small relative differences are enormously amplified, leading eventually to record spreads between debts and debtors perceived to be risky and those perceived not to be, even if that perception is distorted or outright incorrect. As we have said, fear generates self-fulfilling prophecies. As interest rates spiral higher for supposedly risky borrowers, they become less and less able to pay, and default becomes a certainty.
Imposing austerity measures only makes the situation worse, as it forces a contraction that further impairs ability to pay. This is the situation the European periphery finds itself in, and the fear is spreading to include the centre. Today France is in the crosshairs, and even German bond rates are rising.
In contrast rates in the US are falling into negative territory, reflecting the desperation of investors looking for a safe haven and prepared to pay for the privilege. Yields are low because the market is not asking for higher returns, but for a means to preserve capital. The market sets interest rates, not central bankers or governments who only chose a rate to defend, and not ratings agencies without a shred of real credibility left after their performance of recent years.
Interest rates on short term US government debt should stay low throughout the coming period of deleveraging. Short term treasuries represent one of the safest options available, as they are highly liquid, and liquidity will matter more than almost anything else in the depression we are rapidly descending into. Longer term debt may well be a different story, as that has the added risk of having to wait far too long to be repaid, or selling into the secondary market.
Asserting that US treasuries are risky deters ordinary people from seeking the relative safety they offer, even while the insiders take full advantage of it. Similarly, warning people away from US dollars while telling them to hold their nerve in the markets, benefits only those insiders who seek to keep the bubble inflated for long enough to extract their own wealth from a collapsing system.
The US dollar (and other safe haven currencies such as the Swiss franc) is set to benefit, during the period of deleveraging, from the same flight to safety that treasuries will enjoy. It is still the reserve currency, and is likely to stay that way for several years at least. As dollar denominated debt (of which there is more than any other kind worldwide) deflates, demand for dollars, from those seeking to pay down that debt, will push up their value.
The inflation obsession, which central bankers are only too pleased to encourage, also continues to deter people from protecting themselves. Those who are afraid of inflation or hyperinflation will not address the threat of debt or hold the cash that will remain king as the debt bubble bursts and deleveraging aggravates the credit crunch. It is deflation - the collapse of a pyramid of excess claims to underlying real wealth - that we are facing. That is the inevitable result of a bursting bubble.
Widening credit spreads will send the interest rates payable on the debts of ordinary people, companies, banks and lower levels of government through the roof, even as the rate payable on the debts perceived to be safest falls and remains low. At the same time, monetary contraction, credit destruction, spiking unemployment, benefit cuts and skyrocketing bankruptcies will increase the burden that debt represents.
Actual cash will be scarce and few will have access to much of it. Under such circumstances, people will be forced to sell assets for pennies on the dollar to those who still have purchasing power. This is a recipe for extreme wealth concentration, and that, as we are already seeing around the world, leads to increasing social unrest. People need to protect themselves while they still can, but listening to the mainstream media and central authorities is emphatically not the way to do so.
The effect of the US downgrade is ironically far more likely to be felt in Europe than in America. Other triple-A sovereign debtors perceived to be riskier than the US are now at risk of being downgraded, and where fear has already a foothold with respect to sovereign debt default, such moves are likely to aggravate it. Attempts to restore confidence are likely to backfire badly, as existing adverse risk perception merely makes such moves appear desperate, so that they tend to be interpreted as evidence of major problems rather than as reassurance.
Failure is likely to be followed by overtly defensive moves such as the reimposition of capital controls and increasing protectionism, which will only encourage greater fear and greater capital flight. Confidence is ephemeral, and once damaged it can be almost impossible to revive until the underlying imbalance has been resolved, and we are years of deleveraging away from that point.
It is clear the the European Financial Stability Fund, recently increased but still obviously insufficient to cover even the sovereign debt problems already admitted to, cannot solve the rapidly escalating crisis. The scope of this is increasing dramatically as financial contagion spreads to larger states with more intractable debt problems. The European Stability Mechanism, intended to be implemented as a permanent solution in 2013, will never have a chance, as monetary union will long since have been overtaken by events before it can be established.
The European centre has no mandate for further integration, bought, as it would have to be, through the centre agreeing to shoulder far more financial risk than it has done so far. That will likely prove to be politically impossible. The countries of the periphery, caught in a downward spiral of increasingly severe austerity measures and exploding debt, will ultimately resist, perhaps violently, the enormous loss of sovereignty greater integration would involve.
The goodwill necessary to build consensus or render burden-sharing acceptable does not exist, and acrimony is increasing as the situation continues to deteriorate. Larger political accretions become fissile as there is not enough to go around and divisions grounded in history become accentuated anew. This is clearly the risk for Europe.
While rallies are kind to policy makers, casting them in a gloss of apparent competence and effectiveness, declines abruptly strip away the comforting illusion of central control. Policy makers appear increasingly incompetent and out of touch with reality as events unfold far more rapidly than they can be responded to. In reality there is little they can do faced with a bubble blown over at least three decades. Once blown, bubbles always implode.
The demand artificially brought forward during the boom years must be repaid with years of falling demand for almost everything, as difficult as that is to imagine from the top of the pyramid. That is the last thing people are expecting, but it is already underway. Even commodities appear to have topped on speculation going into reverse, and falling demand will accentuate falling prices. The growth dynamic is going into reverse, and with it many of our preconceived and deeply held notions.
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SocGen Stock Tumbles, Leads Fall in French Banks
by Adria Cimino and Sonia Sirletti - Bloomberg
Societe Generale posted a record decline and led a drop in French banking shares as the cost of insuring the country’s government bonds increased. UniCredit, Italy’s biggest bank, paced a retreat in Italian banks after the country’s credit-default swaps widened. Societe Generale shares slumped as much as 23 percent and were down 16 percent at 21.89 euros at 4:27 p.m. in Paris. Credit-default swaps on the bank rose 29 basis points to a record 299 basis points.
Societe Generale "categorically denies all market rumors," Emmanuelle Renaudat, a spokeswoman for the French bank said in an interview. She declined to be more specific. Bank shares lost 5.3 percent, for the biggest decline among the 19 industry groups in the Stoxx Europe 600 Index and the steepest drop since May 2009. French and Italian banks led the retreat. BNP Paribas SA shed 11 percent to 35.06 euros and Credit Agricole SA sank 15 percent to 5.82 euros.
"If credit default swaps on France are under attack, that’s not a good sign," said Yves Marcais, a sales trader at Global Equities in Paris. "That means that France is under attack and that’s worrisome. French banks hold a lot of French bonds." The cost to insure French government debt against default rose 10 basis points to a record 171 basis points, according to CMA.
The FTSE Italia All-Share Banks Index fell as much as 9.4 percent, the most since May 2010. UniCredit dropped as much as 9.1 percent, and was down 8.9 cents to 98 cents by 4:40 p.m., giving the bank a market value of 19 billion euros ($27 billion). Intesa Sanpaolo SpA, the second-largest lender, lost as much as 13 percent, and was down 17 cents to 1.14 euros.
Italian government officials are meeting representatives of labor unions and business executives in Rome to discuss the country’s austerity initiatives amid the euro region’s debt crisis. The meeting follows the Aug. 6 announcement by Prime Minister Silvio Berlusconi that Italy will balance the budget in 2013, a year earlier than previously planned, to prevent a contagion to Europe’s third-biggest economy.
The European Central Bank bought Spanish and Italian bonds today, according to four people with knowledge of the transactions. The amount of securities acquired by the central bank was smaller than in the past two days, said one of the people, who asked not to be identified because the trades are confidential.
An ECB spokesman declined to comment on whether the central bank bought the bonds. European Central Bank President Jean- Claude Trichet signaled on Aug. 7 he was ready to start buying Italian and Spanish debt.
Investors currently demand about 90 basis points of extra yield to buy 10-year French debt rather than German bunds, even though both carry AAA grades from the major rating companies. That spread is almost triple the 2010 average of 33, and compares with 17 in the second half of the previous decade.
French bonds are the most costly AAA government securities to insure as investors raise bets that top-rated euro-region nations may be next in the firing line after the U.S. was downgraded by one notch to AA+ by S&P on Aug. 5.
French Fried Banks: Euro Financial Losers
by Niamh Sweeney - The Street
French banks fell victim to mounting speculation Wednesday that France's triple-A credit rating may be under threat, causing prices to plunge to two and a half year lows. Shares of Societe Generale had lost 19% of their value by mid-afternoon Wednesday -- the biggest drop since January 2009 -- but recovered slightly to finish down 14% for the day when European markets closed a short time ago. BNP Paribas sank 10%, while Credit Agricole suffered a 13% drop.
Attention has turned to the remaining triple-A nations following last week's Standard & Poor's downgrade of U.S. sovereign debt. France, with a debt-to-GDP ratio of 84% and a budget deficit of 6%, has come under most scrutiny.
Five-year French credit default swaps were trading at 1.63% Wednesday - double the rate asked to protect German debt, even though both countries are rated triple-A. Meanwhile the spread between French and Germany 10-year bonds widened to 87 basis points Wednesday, even as yields on French 10-years fell slightly to 3.104%.
The French president Nicholas Sarkozy, who returned to Paris from the Cote d'Azur unexpectedly on Tuesday, met with key cabinet ministers and the governor of the Bank of France to consider new measures to cut France's budget deficit, which he described as "imperative," according to published reports.
French government estimates of 2% economic growth this year, on which current deficit-cutting efforts are based, have been rubbished after second quarter growth fell back to 0.3% from 0.9% in the first quarter. France has a 6% deficit-- the highest of any triple-A rated nation.
[Updated] Why is Socgen offering 12-month gold for less than spot? Or is it a typo?
by Izabella Kaminska - FT Alphaville
[ATTENTION - It is very possible the data in the Reuters chart could be a typo in the Reuters or LBMA system]
Something is afoot at the French banks.
At pixel time Societe Generale was trading 11.5 per cent lower:
BNP Paribas was off 7.5 per cent:
We have no idea what’s suddenly motivated these price falls, though we did notice that Societe Generale (a bullion bank) was recorded offering 12-month gold forwards in the London bullion market at a rate lower than the one-month rate.
This (we think) is pretty rare:
Could the French banks have a large exposure to the Swiss franc via their position as prominent commodities financiers? (There are other rumours of France being downgrading, but how many times has that one gone round the village green?) Notably this sell-off has arrived without any parallel sell-off in Italian or Spanish bonds.
Of course, we stress that’s only a theory. We have no idea. And would not want to do a Daily Mail.
Commerzbank Profit Drops 93% on Greek Debt: €760 Million in Losses
by Nicholas Comfort - Bloomberg
Commerzbank AG, Germany’s second- largest lender, said quarterly profit slumped 93 percent after writing down the value of Greek bond holdings.
Net income fell to 24 million euros ($34.4 million) in the three months to June 30, from 352 million in the year-earlier period, the Frankfurt-based bank said today in a statement. That missed the 34.4 million-euro average estimate of 11 analysts surveyed by Bloomberg. The shares rose the most in three months as operating profit at the "core bank" more than doubled.
Commerzbank booked 760 million euros of impairments on Greek sovereign bonds as European banks write down their holdings as part of a deal to help bail out the country. The gain in operating profit countered yesterday’s announcement that Chief Financial Officer Eric Strutz plans to leave when his contract expires in March. "The earnings were very positive if you strip out the Greek writedown," said Dirk Becker, a Frankfurt-based analyst at Kepler Capital Markets who recommends buying the shares. "It’s never good to unexpectedly lose a CFO, but at least he is staying until next year and it appears he wasn’t fired and is leaving for personal reasons."
Commerzbank rose as much as 9.7 percent and was up 5.8 percent to 2.26 euros as of 9:15 a.m. in Frankfurt trading. The stock is the worst performer on Germany’s benchmark DAX Index this year, slumping 49 percent. Deutsche Bank AG, Germany’s largest lender, fell 19 percent in the same period.
The bank said today that the debt crisis has hurt the stability of markets, a precondition of reaching its full-year earnings targets. "The targets set in the year 2009 are still conditional upon stable markets, which we are presently only seeing to a restricted extent owing to the sovereign debt crisis," Chief Executive Officer Martin Blessing said in the statement. "A return to more stable markets is dependent on how the current crisis develops."
The bank follows BNP Paribas SA, Deutsche Bank and other European lenders in writing down holdings of Greek sovereign debt after signing the Institute of International Finance’s rescue proposal last month. The plan requires investors to take an average 21 percent loss on holdings that mature by 2020. "We also carried on reducing our holding of securities from the peripheral countries of the euro zone and we intend to continue to pursue this reduction strategy," Blessing said.
Commerzbank cut its sovereign risks related to Greece to 2.2 billion euros as of June 30, from 3 billion euros six months earlier, the bank said. Italian risk was cut 10 percent to 8.7 billion euros in the period while exposure to Spain declined 6.5 percent to 2.9 billion euros and Portugal remained unchanged at about 900 million euros. The figures for June 30 don’t include risks from asset- based finance shipping, the bank said.
Europe’s biggest banks stand to lose 20.6 billion euros on their Greek government bonds after lenders in the region pledged to contribute to the new rescue package for Greece announced on July 21. Strutz, 46, who joined the bank in 2001 and became finance chief in 2003, told the supervisory board he doesn’t wish to extend his mandate, the bank said. As a management board member since 2004, he helped lead the bank during the purchase of unprofitable rival Dresdner Bank before the 2008 collapse of Lehman Brothers Holdings Inc.
Strutz, who plans to spend more time with his family, is "convinced" the bank’s strategy is correct and doesn’t have a conflict with Blessing, according to an interview with a Commerzbank employee magazine.
Operating profit at the so-called core bank, which excludes asset-based finance where the Greek writedown was booked as well as the portfolio restructuring division, rose to 913 million euros in the quarter from 397 million euros. Earnings at all four divisions of the core bank rose. Commerzbank cited lower costs at its private customers unit and said a "stable" German economy benefitted business with mid-sized companies.
Commerzbank said it will probably have to put aside less money for risky loans this year. Loan-loss provisions are likely to be less than 1.8 billion euros in 2011 compared with the previous estimate of 2.3 billion euros, the lender said. Commerzbank said June 7 that it completed a 5.3 billion- euro share sale in addition to raising 5.7 billion euros from selling conditional mandatory exchangeable notes to repay government aid.
Blessing said in April that the bank planned to repay about 14.3 billion euros in so-called silent participations to Germany’s Soffin bank-rescue fund by June through the sale of new shares and use of excess reserves. The lender received more than 18 billion euros from the state after agreeing to buy Dresdner two weeks before the collapse of Lehman Brothers.
Soffin maintained its stake of 25 percent plus one share in the lender. Commerzbank said in May that it had already repaid 4.3 billion euros of silent participations, a form of non-voting capital used in Germany, after completing the first step of the capital increase.
The second side of the financial storm
by Todd Harrison - Marketwatch
"Outside in the cold distance, a wildcat did growl. Two riders were approaching and the wind began to howl."
It’s easy to finger the bears as a cabal of pessimistic pundits who root against the world but following the worst decade in financial market history, they’ve earned the benefit of their own market doubt. As negative headlines abound and social mood sours, some might view the mounting malaise as a contrary indicator. One could argue that the prolonged period of substandard performance is on the margin constructive; that a regression to the historical mean would suggest double-digit returns for the foreseeable future.
I would agree, if not for the fragility of the global market construct and the magnitude of the economic condition. We often discuss the current crossroads; government drugs that mask the symptoms after years of societal largesse versus medicine that cures the disease in the form of asset class deflation and debt destruction and restructuring. We repeat this often for good reason: it’s true.
I may be off base — I’ve learned to stay humble or the market will do it for me — but a single word continues to resonate in my mind’s eye as we edge our way through this historic juncture. That word is “cumulative.” As offered at the Minyanville retreat in Ojai in 2005, “The problem that comes from engaging in high-risk behavior for which the consequences are absent, even if only temporarily, is that such high-risk behavior begins to appear normal and the entire scale of risk gets adjusted and pushed out.”
Therein lies the fatal flaw of our current conundrum. We’ve been pushing risk further out on the time continuum for such a long time that it’s become an accepted — dare I say normalized — pattern that interconnects the world through a tangled web of derivatives.
Last year, I wrote that we were in the eye of the financial storm, a relative calm between the first phase of the financial crisis and a sovereign sequel that’ll flush — and perhaps reset — the system. As we navigate that near-term reality, one thing is clear: this decade will require steadfast stamina and proactive patience. While the first half will be focused on preservation and perseverance, the back nine will be ripe with rewards.
Some may view the above-mentioned vibe as overtly negative but I’ll offer a different take. I shared the following thoughts in September 2008 and they’re equally apt today as the second side of the storm gains steam. There are many ways to view this seismic shift: anger (as expressed by Main Street), sadness (as savings are destroyed), fear (as reality bites), and confusion (as folks try to understand how this could ever happen).
And there’s anticipation, as we cast an eye forward and look for the phoenix that will eventually arise from the scorched earth. The unfortunate capital market destruction is an inevitable comeuppance, the cumulative result of risk gone awry. It’s been percolating under the seemingly calm surface for years, magnified by financial engineering and consumed by an immediate gratification society.
The socioeconomic consequences will be pervasive as Mother Nature unleashes her pent-up wrath and explores the other side of the business cycle that politicians and policy makers have tried so hard to avoid. It’s certainly scary, as new beginnings typically are; therein lies the opportunity. The media portrays the Great Depression as one where everyone in America stood on street corners or waited in a bread line. A closer look shows that, similar to our current situation, economic hardship for the middle class began well before 1929.
We’ve got a few lean years ahead but that’s nothing to fear. In fact, it’s a healthy and positive progression. To get through this, we need to go through this and, as painful as the process is, it takes us one step closer to an eventual recovery. I view the Great Depression as the framework for optimism. Most of society worked, great discoveries were made and formidable franchises were established.
Disney built a global franchise through that period. Hewlett-Packard was born on the back-end. Texas Instruments, Tyson Foods, and Continental Airlines were birthed. Indeed, if the greatest opportunities are bred from the most formidable obstacles, we’re about to enter a most auspicious era.
This will be a bitter pill to swallow, particularly for the mainstream American who doesn’t know a derivative from a dividend. We can point fingers and wallow in the “why” or take a deep breath and begin the process of recovery.
It’s unfortunate that the structural foundation of capitalism had to shake before people — and policy makers — paid attention to the root causes of our current conundrum but we can’t dwell on what was; we need to focus on what can and will be. Surround yourself with people you trust. Practice risk management over reward chasing. Preserve capital, reduce debt and become financially aware of your surroundings. It won’t be an easy road but it won’t be impossible either.
For as my grandfather Ruby used to tell me, “This too, shall pass.”
Fast forward to today
Minyanville editor-in-chief Kevin “Pepe” Depew offered the following thought in 2008; and I quote,
“A Depression doesn’t run hot and fierce like some crazed meth burner. A Depression is methodical, purposeful, patient. It will build a shelter out of tree branches and newspaper, light a small, well-contained campfire and wait you out, brother. While you feed on the empty calories of denial and popcorn, it will quietly gather shards of broken dreams and fashion them into a terrible weapon of blunt force reality.”
As unconventional as that view was at the time, the events of the last few years have validated his perspective; ironically, as that very same point of recognition manifests, we’ll edge closer to a secular market bottom.
The causal factor for this modern stealth depression can be traced to the job market; while the Bureau of Labor Statistics maintains the unemployment rate is hovering around 9%, they’ve missed the mark in more ways than one. I understand employment is a lagging indicator coming out of any recession, but I’ll share the following fare:
- The “underemployment” rate, which includes those who’ve taken a part-time job to make ends meet or stopped looking for work altogether, is 20% (one in five).
- The unemployment rate for 16-19 year-olds is 25% (one in four).
- The unemployment rate for 20-24 year-olds is 15% (one in six).
- And perhaps most eye-popping, 15% of Americans are on the food stamp program (one in six!).
The most important takeaway from the evolving dynamic in social mood is this: identifying a personal balance isn’t just about living within one’s means; it’s about redefining what those means are and adjusting your boundaries.
If our past was focused on wealth, accumulation and consumption, the next few years will witness a migration toward something altogether more austere, if not more sensible. My personal view is that the stock market could retest the March 2009 lows in 2013. That doesn’t make it right, and the goal isn’t just to position yourself to profit if you’re correct, but to persevere if you’re not.
Debt reduction and the rejection of — and guilt projection toward — materialism will continue what began in 2008. It won’t just be about doing more with less, but doing less… period, and finding happiness through avenues other than money.
Rally Masks Real Fears
by Tom Lauricella and Jessica Silver-Greenberg - Wall Street Journal
Investors Express Little Confidence in Policy Makers to Tackle Real Problems
A day after a scary plunge, financial markets got a boost Tuesday from the Federal Reserve's pledge to keep interest rates low. But the much-needed rally, coming in another wild, skittish session that sent the Dow Jones Industrial Average seesawing, did little to erase investors' underlying fear: Can policy makers manage the significant headwinds buffeting European and American economies?
A promise by the Fed to keep rates "exceptionally low" until 2013 and some new, but vague, language about the "tools" at the central bank's disposal to stimulate the economy was enough to spark a 430-point gain in the Dow Jones Industrial Average—a partial recovery after the benchmark index had dropped more than 1,000 points in the previous three trading days.
While the Fed's move may have stanched the bleeding in the stock markets and soothed frayed nerves, investors questioned its impact on the real economy, with interest rates already having been at rock bottom for nearly three years. "Whatever benefit you would usually get [from lower Treasury yields] is diminished," says Eric Lascelles, chief economist at RBC Asset Management, which manages roughly $250 billion.
In fact, even as the stock market rallied, yields on 10-year Treasurys fell to record lows, a sign that investors expect the economy to remain weak . "The Fed has spent a lot of its bullets," says Mead Briggs, a retired investor who headed up bond trading desks on Wall Street for many years. "The real focus lies on what's going on with the political side of the equation. That's where the problem needs to get solved, not what the Fed does."
While the credibility of policy makers has historically been a concern for emerging-markets investors, it is unusual for political fears to play such a big role in market sentiment in the world's largest economies. Yet the erosion in confidence in the ability of political and monetary authorities to handle the challenges posed by U.S. and European economies saddled with massive loads of debt has been at the root of the market's latest bout of turmoil.
On one side of the ledger, investors express frustration with the perceived unwillingness among government officials on both continents to make necessary choices that would be unpopular in the short-term with voters. In the U.S., the flashpoint among investors was the political acrimony over raising the debt ceiling. As the clock ticked down toward a possible default, investors voiced disbelief that not only had the fight dragged on but that it was resulting in a budget reduction plan that fell far short of the "Grand Bargain" that had seemed within reach just a week before.
The disappointment at the debt-ceiling deal was amplified by last week's decision by Standard & Poor's to strip the U.S. of its triple-A credit rating for the first time ever. For Mandy Williams, the wrangling over the debt ceiling was the last straw. The 54-year old entrepreneur, who largely manages her own investments, worries that politicians lack the courage to legislate real sacrifice and savings. Ms. Williams, who lives in Houston, moved roughly $10,000 from growth stocks to gold last week. "There's simply no political will to improve jobs or employment," she says.
In Europe, the frustration has been building for months, spreading from the continent's periphery to the core economies of Spain and Italy. A challenge as big as the European debt crisis "requires leadership and coordination and we just haven't gotten that," says Michael Story, a London-based economist at Western Asset Management. The second loss of confidence is in the ability of central banks to do much more to shelter investors, businesses and consumers from the pain of massive overhangs of debt. "Policy makers have been scratching the bottom of the barrel," says RBC's Mr. Lascelles. "The capacity of monetary policy to deliver [relief] is fading."
Aside from the debt ceiling fight, the issues driving the recent loss of confidence have been swirling since even before the 2008 financial crisis. In 2008, governments and central bankers were able to step in to provide liquidity and shore up confidence, albeit with missteps along the way. This time around, investors sense there is no quick fix. "We've gone through the denial phase and we've been seeing some of the anger phase but we're not quite in the acceptance phase," says Stephen Cucchiaro, chief investment officer at Boston based Windhaven Investment Management, which manages $6.6 billion.
Mr. Cucchiaro says he views the current crisis as an opportunity for elected officials to deal with structural fiscal problems in the U.S. when it comes to both entitlements and the tax code. "Both sides need to come together," he says. "But no-one is doing that."
Housing and the jobs market are two areas where investors say government help is needed. Both have remained troubled despite the Fed's moves. Part of the problem for political leaders, some investors say, is that they have not yet come to grips with the new economic environment. "We've had twenty years of pretty strong and less volatile economic growth," says Peter Fisher, global head of fixed income at BlackRock Inc. "It's really hard for politicians to adjust to lower and more volatile economic growth than they are used to."
Bernanke’s Interest-Rate Timeframe Draws Most Negative Votes in 18 Years
by Craig Torres and Joshua Zumbrun - Bloomberg
Federal Reserve Chairman Ben S. Bernanke’s plan to hold interest rates near zero through at least mid-2013 provoked the most opposition among voting policy makers in 18 years as central bank consensus frayed.
The Fed chief achieved unanimous support on the Federal Open Market Committee in 2008 when he lowered interest rates to near zero, and in 2009 when he launched $1.73 trillion in bond purchases. Last year, his plan to buy another $600 billion in assets drew one dissent. Yesterday, three policy makers dissented from the decision to apply a specific date to the Fed’s low rate pledge for the first time.
Bernanke’s move shows that a Fed chairman can govern with more than two opposing votes, opening the door to bolder action if necessary, said Roberto Perli, a former economist in the Fed’s Division of Monetary Affairs, which helps craft the language of the FOMC statements. "We have reached the point where Bernanke is taking control and saying we have to do the right thing no matter how many people dissent," said Perli, a managing director at International Strategy & Investment Group in Washington. "It shows the committee can move forward."
Seven members of the panel favored the action. Richard Fisher, president of the Federal Reserve Bank of Dallas, Charles Plosser of Philadelphia and Narayana Kocherlakota of Minneapolis voted no, preferring to maintain the existing "extended period" language. The last time three FOMC voters dissented was on Nov. 17, 1992, under Bernanke’s predecessor, Alan Greenspan.
History of Discomfort
Fed officials have a long history of discomfort with pledges that limit their policy flexibility, minutes of their meetings show. The deterioration of the economic outlook, and the limits of monetary policy when interest rates are already near zero, prompted Bernanke to opt for the time commitment -- even at the cost of three dissenting votes, said former Fed Governor Laurence Meyer. "He must be unhappy about that, but with no regrets," said Meyer, now a senior managing director at Macroeconomic Advisers LLC. "The chairman is the decider, and he will do whatever he thinks needs to be done."
Ten-year Treasury yields touched a record low, and U.S. stocks rebounded from the worst drop since 2008. The Standard & Poor’s 500 Index gained 4.7 percent to close at 1,172.53 yesterday. The 10-year yield fell as low as 2.03 percent before paring its decline to 2.25 percent. The Federal Open Market Committee lowered its economic assessment, saying it now "expects a somewhat slower pace of recovery over the coming quarters." It left the door open for more action, saying it discussed "the range of policy tools available to promote a stronger economic recovery."
The dissents may have weighed against stronger action for now, said Vincent Reinhart, a former director of the Division of Monetary Affairs. The FOMC majority could push for further easing at the Fed’s annual conference in Jackson Hole, Wyoming, later this month, he said. "The dissents signal a strongly divided committee," said Reinhart, a resident scholar at the American Enterprise Institute in Washington. The Bernanke majority "did less than they wanted to probably. But they set themselves up for Jackson Hole to be a midcourse correction."
In previous eras, dissents could signal rebellions against the chairman. On February 24, 1986, Paul Volcker was outvoted when four governors appointed by President Ronald Reagan wanted to lower the discount rate.
Volcker considered resigning immediately, according to the book "Secrets of the Temple" by William Greider. He remained chairman until 1987, when Alan Greenspan was appointed. Meyer, in his 2004 book "A Term at the Fed," said Greenspan built consensus before meetings, sometimes lobbying governors one by one.
There were "two imaginary red chairs around the table -- the ‘dissent chairs.’ The first two FOMC Members who sat in those chairs were able to dissent. After that, no one else could follow," Meyer said in the book. A third dissent would represent "open revolt" against the chairman, Meyer said.
Greenspan faced three dissents on November 17, 1992. Unlike yesterday, the opposition was split. Cleveland Fed President Jerry Jordan dissented in favor of "immediate action" to increase the availability of reserves.= Fed governor John LaWare and St. Louis Fed President Thomas Melzer dissented because they believed the economy was strengthening and central bank policy might "well-establish a basis for greater inflation later."
Yesterday’s dissents highlight a lack of full support for Bernanke’s policies at a time when the central bank is under greater scrutiny. After the Fed announced a $600 billion second round of bond purchases in November, House Speaker John Boehner and three other Republicans sent Bernanke a letter expressing "deep concerns."
"The reality is at the end of the day Bernanke has an operational majority and he’s not afraid to ram things through over the objection of the minority," said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. "There’s nobody on the board who’s likely to dissent, and there’s a handful of presidents who" share Bernanke’s views on monetary easing.
Prior to yesterday’s meeting, there had been 23 dissents during Bernanke’s tenure as Fed chairman. Nine of those came from Kansas City Fed President Thomas Hoenig. He voted eight straight times in 2010 against record stimulus, tying former Governor Henry Wallich’s record in 1980 for most dissents in a single year.
Fisher and Plosser both dissented in March and April of 2008 in favor of less accommodative monetary policy, with Fisher also dissenting three other times that year. The voting membership of the FOMC next year has members less inclined to open disagreement with the majority, as presidents from Atlanta, Cleveland, San Francisco and Richmond rotate onto the committee.
Atlanta’s Dennis Lockhart and Cleveland’s Sandra Pianalto have never dissented. San Francisco’s John Williams will be new to the committee, though his predecessor, Janet Yellen, never dissented. That leaves Richmond’s Jeffrey Lacker as the only president with a history of dissenting, having objected to five previous FOMC statements.
The FOMC has had divisive debates over pegging interest rates to a time period before. In August of 2003, the committee adopted a phrase from Greenspan’s semi-annual testimony in July and said "policy accommodation can be maintained for a considerable period."
Debate on Language
After a unanimous vote to leave the benchmark lending rate unchanged at 1 percent, then-Boston Fed President Cathy Minehan began a debate on the "considerable period" language. "I’m just wondering whether that’s veering a little too much toward the commitment side than we need to or ought to do at this point," Minehan said.
Presidents Jack Guynn of Atlanta, Hoenig of Kansas City, William Poole of St. Louis and J. Alfred Broaddus Jr. of Richmond were among the seven officials who opposed the phrase among a total of 18 FOMC participants. The majority won after Greenspan called a vote. Bernanke, then a Fed governor, argued in favor of retaining the phrase, saying it would "go some way to bringing policy expectations in the market toward what I heard around the table during the entire meeting."
Reinhart, who was involved in formulating the Fed Board’s communication strategy, said a policy maker approached him one day and told him his tombstone would read: "Here Lies Vincent Reinhart, For a Considerable Period."
Fed is as paralyzed as Congress is
by Rex Nutting - MarketWatch
The U.S. economy is slumping, and the word Tuesday from the Federal Reserve is that the central bank is just as paralyzed as Congress is.
The most remarkable thing about the policy statement from the Fed was the wide gulf between the Fed’s diagnosis of what’s ailing the economy and the Fed’s prescribed medicine. The economy is in much worse shape than we thought, the Fed said. And we won’t — or can’t — lift a finger to do anything about it.
Up until now, the Fed had been clinging to a hope that the softening in the economy would prove to be transitory, that temporary factors — such as high energy prices and the supply shock of the Japanese earthquake — were to blame. No longer.
The Fed has come to grips with the reality: If temporary factors “account for only some of the recent weakness in economic activity,” then it follows that permanent, structural or fundamental factors must account for most of our problems. And those problems will take years to resolve. Sure, the Fed made some news by saying that it would likely keep interest rates exceptionally low until the middle of 2013. Never before has the Fed put a date-certain stamp on any of its actions. That sounds like a pretty dramatic announcement, but actually it was a statement of impotence.
The promise to keep interest rates near zero for two more years will do very little to stimulate the economy in the near term. On the margin, the Fed’s promise will help cement market expectations that the Fed won’t be tightening monetary policy any time soon. Everyone already expected the Fed to sit tight for a long time, so what does it really achieve?
The mid-2013 promise falls well short of the market’s hopes, but it was as far as Federal Reserve Chairman Ben Bernanke could push his committee. Three of the 10 members of the Federal Open Market Committee dissented, which by central-banking standards is practically a mutiny.
The three dissents tell us that the Fed won’t implement a new round of bond buying — not unless the situation gets a lot worse. The remaining arrows in Bernanke’s quiver will stay right there, unused. And the economy — and the market — must fend for itself.
Interpreting the Fed: what Bernanke really told us
by Gavyn Davies - FT
Opinion is sharply divided about what the Fed intended to signal in the statement issued on Tuesday. Some have seen the statement as very dovish, because it said that the Fed intended to leave short rates at "exceptionally low levels" until mid 2013 – the first time that a specific date of this sort has ever been set by the FOMC.
Others, however, concluded that the statement contained nothing really new, since the markets had already assumed that short rates would be close to zero for the next two years. Furthermore, the fact that there were three dissents from the majority decision has led some to deduce that the further large step to more quantitative easing (QE3) is still a long way off. On this view, nothing really changed.
One way of trying to assess whether the Fed eased policy on Tuesday is to use the Taylor Rule, which translates economic conditions into the "appropriate" setting for monetary policy.
There are many versions of this rule doing the rounds in economic research, but I am going to use the one which some economists say is the closest to that used by the FOMC. This was published by Glenn Rudebusch of the San Francisco Fed in June 2010. The equation translates the core rate of inflation, and the gap between actual and structural unemployment, into the appropriate short term interest rate using the Fed’s historical response function. (Strictly, this does not give us the "correct" short rate, just the one which the Fed would set if it acts in the same way as it has on average in past 20 years.)
Using the FOMC’s most recent forecasts for core inflation and unemployment in 2011 Q4, we find that the implied fed funds rate is -2.5 per cent. However, in order to discover what rate the Fed should actually set today, we also need to take into account of the expansionary effect of QE. Rudesbusch also enables us to do this. On his central estimates, updated for the arrival of QE2 since he published his research, the increase in the Fed’s balance sheet has been equivalent to a reduction in the short rate of about 3.2 per cent. Consequently, the "correct" short rate right now would be about 0.7 per cent – fractionally higher than where it is today.
This, and the fact that the FOMC believes that inflation expectations are no better than "stable", probably explains why the Fed has been reluctant to ease monetary policy further as economic activity has slowed down in recent months. Even Fed chairman Ben Bernanke and his dovish supporters have given no sign of any relaxation until the statement on Tuesday. Unlike last year, there has been no indication from them that monetary policy is "too tight".
What about the future for short rates? After the June FOMC meeting, the committee published its central projections for core inflation and unemployment for 2012 Q4 and 2013 Q4. We can use these to interpolate their projections for mid 2013, the relevant date for the new commitment made on Tuesday.
Using the economic projections made in June, the Taylor Rule suggests that the correct level of the short rate in mid 2013 would be 3.1 per cent, if the size of the Fed’s balance sheet remained unchanged until then. In other words, based on what the Fed expected for the economy in June, it was reasonable to expect that there would be a progressive tightening in monetary policy in the next two years, either coming from higher short rates, or a reduction in the size of the balance sheet.
However, this expectation has now changed, mainly because the Fed said that the paths for real GDP and unemployment are now worse than they expected in June, both in the past and in the future. Furthermore, the downside risks to this forecast are said to have increased, and inflation is thought likely to settle at rates "at or below" the 2 per cent which is deemed consistent with the Fed’s mandate.
We do not know the precise forecasts which the Fed is now using, but we can make a reasonable estimate. I assume that the unemployment rate projected for mid 2013 is now 8.5 per cent (up from 7.6 per cent before), while the core inflation rate is 1.5 per cent (down from 1.7 per cent previously). On this basis, the correct short rate in mid 2013 would be 1.1 per cent, assuming that the Fed leaves its balance sheet unchanged in the meantime.
The Fed has now committed itself to leave rates unchanged at "exceptionally low levels" until mid 2013. So is it intending to pursue a monetary policy which is easier than the Taylor Rule suggests? Not necessarily. For one thing, "exceptionally low" rates could be taken to be consistent with rates rising to 1 per cent. For another, the Fed has not told us what it is assuming will happen to its balance sheet between now and 2013. If the Fed’s security holdings were to shrink by about one third over that period, roughly reversing the effects of QE2, then the appropriate short rate would be around its current level: close to zero.
Either way, the Fed does not seem to have committed itself to any easing in monetary conditions in the next two years. It is not yet ready to get ahead of the curve, and take pro-active steps to prevent the economy from slowing further. It is quite likely that it will ease policy further if unemployment and GDP growth deteriorate, but inflation expectations seem to be standing in the way of that happening pre-emptively.
Mr Bernanke showed that he will not allow a few dissenting voices on the FOMC to stop him easing further if he believes that conditions warrant such a move. That constitutes a smidgeon of dovish news, compared to what we knew before. But by that time, the economy might be in recession.
The Fed’s Stuck
by Alen Mattich - Wall Street Journal
With equity markets melting down at an accelerating pace over the past few weeks, central bankers will be looking to do another round of emergency responses. To that end, all eyes will be on the Federal Reserve.
If the Fed persists with another round of unorthodox medicine, say QE3, it will be perpetuating the same catastrophic stupidity it did last year. That’s because it would be misdiagnosing the problem and thus end up dosing the patient with another dose of what’s in effect, poison.
Equity markets are not selling off because of sovereign debt worries in Italy or the Standard & Poor’s downgrade of U.S. debt, or even of the latest indication that the global economy is slowing. Equity markets were rising through June and July when there were already signs of a global economic relapse. If the S&P downgrade really mattered, why then are Treasury bonds–presumably the asset class most at risk–rocketing? And Italy’s woes are merely the latest manifestation of the euro zone sovereign debt crisis that’s been rolling around for the best part of two years.
No, the markets are responding to the end of the Fed’s QE2 program at the end of June. Indeed, the S&P 500 is nearly back down to levels of a year ago when Fed chairman Ben Bernanke gave his Jackson Hole speech, paving the way for more quantitative easing.
Ostensibly, QE2 came about because the Fed was worried about deflation. In fact, as the Fed admitted later on, it was because Bernanke and co. were targeting asset prices. Not only were rising equity prices meant to create a wealth effect to boost the underlying confidence in the U.S. economy and, thereafter, consumption, but they also were seen as a barometer of how well the central bank was doing.
To that end, the Fed inflated equity prices far above their historic norms–between a third and a half, depending on whether you use replacement costs of assets or cyclically smoothed earnings as your valuation methodology. Without QE, equity prices will have a tendency to revert to these trend levels. And that’s what they’re doing now.
They may fall even further below trend because of a secondary effect of the last round of QE, rampant commodity price inflation. The surge in commodity prices, that tracked equity prices, also acted as a huge tax on the struggling U.S. economy. It ate away at household resources, hitting ordinary people’s consumption. So, while rampant equity prices allowed bankers and the rich to behave as if the fiscal crisis never happened, food and energy price rises crippled the rest of the population.
Will the Fed do it again? Possibly. After all, it has been instrumental in inflating asset bubbles for at least 15 years and largely the same people are in charge now as have been the whole while. But to repeat these mistakes would be criminal.
So what should it do instead? John Hussman, of Hussman Funds, puts his finger on the problem in his latest weekly note. What the U.S. economy needs is a restructuring of bad debt. Until this restructuring happens, the economy will remain on its knees. It can be argued that the Fed is seeking to restructure these bad debts through inflation. Perhaps. But maybe it should use its regulatory powers to do as much as it can too.
Merkel faces revolt over eurozone deal
by Quentin Peel - FT
Battle lines are being rapidly drawn up in the German Bundestag for what promises to be a bruising debate over the crisis measures to stabilise debt markets in the eurozone.
Angela Merkel, the chancellor, and her finance minister Wolfgang Schäuble face a revolt among their own supporters in both the Christian Democratic Union and the Free Democratic Party, junior partner in the ruling coalition in Berlin, over the deal they agreed last month with their 16 eurozone partners in Brussels.
The complex political landscape means that Ms Merkel is determined to resist pressure from her partners, and from the European Commission, for any further measures – such as increasing the size of the €440bn European Financial Stability Facility, or introducing eurozone bonds – for fear of losing her parliamentary majority.
Some members of the CDU have already called for an emergency party conference to debate the government’s entire eurozone strategy. They include new powers for the EFSF to buy eurozone government bonds in the secondary market, and to issue precautionary loans to countries with liquidity problems, and to recapitalise banks.
A separate move by dissidents in the FDP to call an emergency session of the Bundestag seems likely to be blocked, because the opposition Social Democrats (SPD) back the government line to wait for the parliament to reconvene in September.
The German government is also facing a highly critical press in the wake of the weekend decision by the European Central Bank to buy Italian and Spanish bonds, a move that was welcomed by Berlin, although it is opposed by the Bundesbank, Germany’s highly independent central bank, in Frankfurt. The calls for an emergency party conference have come from the Hesse state branch of the CDU, and from the head of the party’s youth wing, Philipp Missfelder, who is a member of the party’s national executive.
In an interview with the mass circulation Bild newspaper on Tuesday, Mr Missfelder said he would call for an emergency party conference at the next meeting of the executive on August 22, if Italy were forced to seek help from the eurozone rescue fund. "The party has a right to participate in such momentous decisions," he said. But he left an escape route for the party, because Italy is technically not getting help from the EFSF rescue fund, but from the European Central Bank.
A more serious threat to Ms Merkel’s 21 seat majority in the Bundestag comes from the liberal Free Democrats, who are fighting desperately to recover from a slump in popularity, which has dropped from 14 per cent to barely 3 per cent in the polls since the last election in 2009. One third of the delegates at the last FDP party conference voted for a resolution rejecting the plans for a permanent European Stability Mechanism, which is supposed to replace the EFSF from 2014.
On Tuesday, Philipp Rösler, the economy minister and party leader, came up with a proposal for a European "stability council" which would set "stress tests" to measure the competitiveness of individual eurozone members, and impose automatic sanctions to force reforms upon them. The move was seen as an attempt to head off a growing revolt from his backbenchers.
Ms Merkel insists that she will deliver her majority in favour of the deal. If more than 21 supporters refused to back the deal, she would be forced to rely on the opposition SPD and Greens, both of whom are in favour. That would ensure German approval for the eurozone reform package, but it would be politically devastating for the chancellor not to be able to count on majority support from her own ranks, and could cause the government to fall.
Sigmar Gabriel, SPD chairman, on Tuesday promised his party’s support once again, and argued that the German government should go further, and allow eurozone bonds to be introduced, ensuring easier borrowing for the most debt-strapped eurozone member states.
Beware the ECB’s brave new world
by Martin Sandbu - FT
Jean-Claude Trichet, president of the European Central Bank, has torn up his institution’s implicit rule book by buying Italian and Spanish sovereign debt. Does this make him Europe’s great defender, who has turned back a near-fatal onslaught by market forces? Or is he rather a Molotov cocktail-throwing radical, tearing down the foundations of the eurozone’s social contract by opening the door to monetised public deficits?
He could, of course, be both. It is quite possible, indeed plausible, that the project of monetary union can only survive if some of the premises on which it was founded – such as a ban on using pooled resources to help member states who cannot pay their debts – are jettisoned. If so, Mr Trichet is indeed a revolutionary, but one whose radical measures aim at preserving the established order.
There is a more likely possibility: that for all its radicalism, the ECB’s action will not have much effect at all. Granted, the immediate impact of the governing council meeting on Sunday and the next day’s market intervention was tremendous. Driving down the sovereign yield of a €1,600bn-a-year economy by almost a full percentage point shows that the ECB is no pushover.
The question is not about the force of the ECB’s punch but about its staying power. Its intervention in the sovereign bond markets of Greece, Ireland and Portugal is instructive in this regard. These are much smaller – more cheaply manipulable – than those of Spain and Italy.
The ECB launched its Securities Markets Programme in May 2010, when the first eurozone rescue of Greece was arranged. It later added Irish and Portuguese bonds to its portfolio. Before this week’s intervention, the SMP held €74bn-worth of government securities from these three countries. That is 14 per cent of the around €520bn of bonds they have outstanding, presumably more if counted at face value.
Since Italian and Spanish bonds amount to some €2,250bn, and trade at higher prices than those of the small peripheral countries, the ECB would need to spend well more than €300bn to hold a similar share. If the goal is to induce markets to offer states low-borrowing costs, this amount of bond-buying is clearly far too timid to succeed. Greek 10-year bonds now yield about 15 per cent; Irish and Portuguese ones about 10. Why expect any more success from buying Italian and Spanish bonds?
The answer depends on what precisely the ECB wants to do: make markets lend at reasonable rates, or permanently substitute its own favourable rates for unsustainable market yields? For now, the answer is surely the former: the ECB – and everybody else in their right mind – must hope the intervention will flip market psychology so that investors return at normal prices. This is not a delusional proposition: everywhere except Greece, the biggest cause of rising yields has been self-fulfilling market worries about market access.
But the effect of policy on market psychology is never mechanistic, least of all in times as uncertain as these. The ECB’s action, instead of reassuring investors, could quite possibly make them think that if such a desperate measure is needed, it is better to get out of the market and stay out until things look better. This could accelerate the crisis. More probably, doubts will simply linger until market panic flares up again.
What then? It will be the true test of the ECB’s radicalism. If markets remain unconvinced that Italy’s or Spain’s market access is secure, the ECB has only one tool left. That is to take over the whole market – buy all new or outstanding Italian or Spanish debt at a certain yield – or promise to do so, which it can only credibly do by actually going ahead.
It is inconceivable that the ECB would do this, and there are reasons why it should not. One is efficacy: it is not clear how Italian and Spanish access to private debt markets at reasonable terms would be secured by supplanting those private markets with monetary financing.
Moreover, purely monetary action cannot provide the public sector with real resources on a sustained basis without those resources ultimately being paid for by the private sector. The usual way that this happens is through an inflation tax: net holders of nominal claims see the real value of their assets eroded. In a currency union this would affect all countries and amount to a real transfer from creditor country citizens to debtor states.
Transfers can happen in other ways: if bonds were not honoured in full, the entire eurozone must help make the ECB whole for its losses. Whichever the mechanism, transfers resulting from monetary policy are anathema to the terms Germany thought it secured for the euro.
But this outcome can only be ruled out by finding another solution, and soon. Creditor nations’ taxpayers are already exposed. Politicians must grasp, then explain, that their money is best protected by putting it explicitly behind the commitments made to solvent but illiquid sovereigns. The obvious way to do this is the most impolitic one: boost the eurozone’s rescue facilities – the European Financial Stability Facility and the future European Stability Mechanism – to a level that can cover the entire eurozone’s gross public financing needs for the next couple of years, some €3,000bn.
This would end the crisis. EFSF and ESM bonds, like US ones, will not face buyers’ strikes, regardless of ratings. It would also be profitable – a point missed by politicians who complain about "unjustified" yields. If markets price bonds irrationally, the EFSF can make money for taxpayers by buying them. Sadly, not everyone has Mr Trichet’s capacity for such radical thinking.
Bail-outs chip away at France and Germany too
by Ambrose Evans-Pritchard - Telegraph
Investors have begun to question whether France and Germany can credibly underwrite the debts of southern Europe without losing their AAA ratings and succumbing to the crisis themselves.
Credit Default Swaps (CDS) measuring risk on German bonds have doubled since early July to 85 basis points, rising above British CDS contracts for the first time despite the London riots. Non-EMU Sweden enjoys lower borrowing costs than Germany. This has not been seen for half a century. "What is happening is momentous," said Andrew Roberts, credit chief at RBS. "The more Europe steps in to buy Italian and Spanish debt, the more Germany shifts towards the group of countries that could be attacked."
French CDS have surged 161 and are now by far the highest of the AAA club. Yields on French 10-year bonds decoupled from core EMU states such as the Netherlands, Austria, and Finland. "France is now on the radar of investors. It is expected to be a back-stop for the bail-out fund but according to the IMF it has to do almost twice as much fiscal tightening to keep its economy on an even keel," said Mr Roberts. The IMF said last month that France had the highest debt ratio of any AAA state this year at 85pc of GDP.
The decision by EU leaders two weeks ago to empower the bail-out fund (EFSF) to buy the bonds of Italy and Spain has profoundly changed the European Project, ushering in a 'Transferunion' and debt pool. This has big implications for the paymaster states. RBS has warned that France may have to accept a rise in its debt-to-GDP ratio to 112pc, and Germany to 110pc, if they ultimately have to raise the EFSF's firepower to €2 trillion (£1.75 trillion).
Stephen Jen, head of SLJ Macro Partners and a former IMF official, said Europe is replicating mistakes made by financial authorities after the Lehman crisis when good banks were merged with bad banks - as with Lloyds and HBOS. This time the destructive "fission" is taking place between solvent and insolvent states. Investors are taking flight before the fission turns "explosive".
Mr Jen said Standard & Poor's downgrade of the US will have knock-on effects for Europe since the rating agency will have to apply the same logic. "On virtually all debt measures, France looks much worse than the US. If S&P includes America's unfunded Social Security liabilities, which it did, it should also include France's contingent liabilities in all of the mega-bailouts. Even Germany's AAA rating may not be assured if Europe remains on its current policy path," he said.
Mr Jen said the ECB itself may pay a high price as it is forced to soak up South Europe's debts. "Italian and Spanish bonds are weakening for very natural reasons. One day, the ECB will need to be recapitalised (bailed out) by governments," he said.
Jean-Claude Trichet, the ECB's president, gave an emotional defence of the ECB's actions yesterday. "It is the worst crisis since the Second World War, and it might have been the worst since the First World War if those in charge had not taken very robust decisions," he told Europe-1.
Professor Volker Grossmann from Fribourg University said the ECB was the only institution that could take on the task. "The EFSF rescue fund cannot bail out Italy and Spain because politicians will never agree to pay these huge sums. They know it would be political suicide. It is a pretence," he said. "The debt crisis will be resolved through higher inflation. That will hurt everybody and raise borrowing costs for Germany," he said.
Criticism is mounting in Germany over the authoritarian creep of the Europe's crisis measures. Otmar Issing, the ECB's former chief economist and the country's most authoritative voice on the euro, said the EMU project was spinning out of control. Far from evolving into an authentic fiscal union with "a European government controlled by a European Parliament, elected according to democratic principles", it is turning into a deformed creature where moral hazard is unchecked and the EU is intruding on sovereign matters.
By subverting the 'no bail-out' clause of the Maastricht Treaty the eurozone is "on a slippery road to a regime of fiscal indiscipline drowning hitherto solid countries in the morass of over-indebtedness." Implicit transfers are taking place without parliamentary approval. "This type of political union would not survive. Its collapse would be brought by resistance from the people. In the past, cries of 'no taxation without representation' have brought war," he said.
Italy's leader Silvio Berlusconi lashed out at Europe yesterday after a leaked letter showed that the ECB had dictated the exact details of Rome's new austerity policies as a condition for ECB bond purchases. "They made us look like an occupied government. They bought the bonds to save themselves, not Italy," he said, according to Il Messaggero. "We're a long way from collective governance capable of scaring speculators. If it's our turn today, it can be Paris's turn tomorrow."
European Bank Stress Measurements Hit Levels Unseen Since Lehman Collapse
by Gavin Finch and Elisa Martinuzzi - Bloomberg
Measures that gauge the level of European banks’ reluctance to lend to one another are approaching levels unseen since the aftermath of Lehman Brothers Holdings Inc.’s collapse.
Banks in the region are paying the biggest premium to borrow in dollars since December 2008, with the three-month cross currency basis swap falling to 90 basis points below the euro interbank offered rate today. The difference between three- month Euribor and the overnight indexed swap rate, a measure of banks’ reluctance to lend to each other, jumped to 0.64 percentage point today, the widest spread since May 2009.
"We’re going back to a post-Lehman scenario where banks are reliant on the ECB and funding is more expensive," said Marcello Zanardo, an analyst at Sanford C. Bernstein & Co. in London. "This may lead to a credit crunch" if banks can’t pass on all their costs.
ECB President Jean-Claude Trichet last week offered banks unlimited money for six months and extended existing liquidity measures to quell concern that southern European lenders may struggle to borrow in the debt markets. The central bank has also started to purchase Italian and Spanish bonds to stem the sovereign debt crisis. Banks deposited 145 billion euros ($207 billion) with the European Central Bank’s overnight facility as of yesterday, the most since August 2010. ECB lending to banks rose by 7.75 billion euros last week to 505.1 billion euros.
'Not a Good Sign'
"Banks are beginning lend more cautiously, and increasingly park their money at central banks," ECB Governing Council member Ewald Nowotny told Austrian state radio ORF today. "Bank deposits at the ECB have risen massively. That’s not a good sign."
The extra yield investors demand to buy bank bonds instead of benchmark German debt surged to 251 basis points on Aug. 8, or 2.51 percentage points, the highest since May 2010, data compiled by Bank of America Merrill Lynch show. The cost of insuring that debt against default surged to a record today. The Markit iTraxx Financial Index linked to senior debt of 25 European banks and insurers rose to 218 basis points today.
Credit Suisse Group AG fell below the lowest price hit during the financial crisis of 2008. The Swiss lender dropped 3.9 percent in Zurich trading to 21.75 francs, the lowest since March 2003. The Bloomberg Europe Banks and Financial Services Index was 0.4 percent higher at the close in London after falling as much as 4.9 percent.
"What you’re seeing is a massive move to deposit cash at the shortest-term maturity, just like we saw a couple of years ago," said Simon Maughan, head of sales and distribution at MF Global Ltd. in London. "International banks are extremely unwilling to lend to southern European banks."
'Spell Out’ Strategy
The ECB’s purchases of Spanish and Italian bonds may be draining liquidity from the interbank markets, analysts said. Unlike the U.S. Federal Reserve’s quantitative easing program, the ECB sterilizes its bond purchases, using term deposits to reabsorb the same amount of cash it spends.
If the ECB chooses to sterilize its Italian and Spanish bond purchases by holding bank deposits of the same size, that could encourage banks to boost their deposits at the ECB rather than lend to each other, analysts said.
"The ECB needs to spell out what the strategy for its bond purchases is and the net cash impact," said Jonathan Tyce, senior analyst for the Bloomberg Industries European banking team in London. "Falls across the banking sector and a rise in Euribor-OIS -- despite falling Italian and Spanish yields -- suggest the market is concerned about sterilization and as a result, negative impacts on bank liquidity."
The yield on 10-year Spanish government bonds has fallen 120 basis points in the past week to 5.06 percent today. The yield on Italian debt of a similar maturity slid 95 basis points to 5.18 percent in the same period.
European Central Bank must go nuclear to save Europe
by Ambrose Evans-Pritchard - Telegraph
A chorus of global economists has called on the European Central Bank to go far beyond pin-prick purchases of eurozone debt. It needs to launch quantitative easing on a massive scale to head off a eurozone debacle, if necessary purchasing half the entire stock of Italian and Spanish debt, they argue.
Stephen King, HSBC's chief economist, said the ECB should drop its ideological opposition to QE and embrace easy money in "exactly the same" way as the US Federal Reserve. "At the heart of the problem is the ECB's unwillingness to be seen 'monetizing' government debt. Yet if the alternative to QE is the collapse of the euro or a descent into depression, then massive expansion of the ECB's balance sheet seems a small price to pay," he said.
The ECB should not 'sterilize' purchases of Italian and Spanish bonds to offset stimulus but instead allow the liquidity to course through the system. Dr King said the eurozone will have to embrace fiscal union in the end or face the same sort of "fiscal anarchy leading to financial implosion" that destroyed post-Soviet rouble area. New York professor Nouriel Roubini called on the ECB to reverse monetary tightening immediately given the darkening global picture. "It should reduce rates to zero, and make big purchases of government bonds," he said.
Frankfurt is unlikely to heed the advice. The bank's president Jean-Claude Trichet, last week stuck to his anti-inflation script and said "we do not do QE". The ECB began buying Spanish and Italian bonds for the first time yesterday, causing 10-year yields to plunge by 90 basis points. However, an ECB statement over the weekend came with too many strings to satisfy investors. The bank is likely to be tested over coming weeks.
David Marsh, co-chairman of OMFIF, said the statement was "half-hearted" and suggested that dissenting German hawks were imposing limits. "The ECB is clearly not going in with all guns blazing," he said. Investors have not forgotten that the ECB failed to stop Greek, Irish, and Portuguese yields from spiralling out of control before each needed a rescue, even though it purchased almost a fifth of their combined debts.
Gary Jenkins from Evolution Securities said Greek yields fell from 12.43pc to 7.35pc in the week following the ECB's first bond purchases, only to creep back up over the next six weeks. Jacques Cailloux, Europe economist at RBS, said the ECB's intervention had stopped a collapse of South European bond markets for now, but ultimately the ECB will have to act as buyer-of-last-resort on a huge scale.
Investors will take advantage of bond rallies to cut exposure to Italy and Spain, shifting the risk onto the ECB and the taxpayer. The crisis will flare up again if the ECB stops buying. Mr Cailloux said private investors will not return to the market until the debts of Italy and Spain are on a "clear declining trend" and there is no longer any serious risk of contagion.
"That simply cannot happen in the foreseeable future. Over time, we believe that ongoing selling pressure will force the ECB – and [the eurozone's bailout fund] EFSF – eventually to hold close to half the long-term traded debt of Spain and Italy or around €850bn. This huge risk-pooling will not come easily and the risk of political fall-out will be large," he said.
The ECB acted on the assurance that the EFSF will take over the responsibility once its new powers have been ratified by national parliaments, which may not be until October. This creates an implicit limit to ECB purchases since the fund is not authorized to lend its full €440bn, and a large chunk of that is already earmarked for Greece, Ireland, and Portugal.
Brussels has called for more firepower, and Citigroup has called for a €2.5 trillion fund to silence all doubts. Yet this is anathema to Berlin, where key figures on Chancellor Angela Merkel's coalition are near revolt. A weekend statement by Dr Merkel and French president Nicolas Sarkozy made no mention of boosting the fund. "Given this, it remains unclear in what size the ECB is willing to intervene," said Giada Giani from Citigroup.
Bundesbank chief Jens Weidmann has been an open critic of bond purchases, warning that such "collectivisation of risks" will undermine EMU. German bail-out fatigue is leading to a tetchy mood and it will not be lost on politicians in Berlin that Germany suffered the biggest stock market fall of any major country in Europe on Monday, with the DAX down 5pc. "It is clear that somebody is going to have to pay for all these bail-outs, and it is going to be the German taxpayer," said David Bloom, currency chief at HSBC.
Mr Bloom said market psychology had broken down across the world over recent days. Barely a month ago the consensus thought recovery was at hand. "We were looking at the end of QE, and exit strategies, and we could see an oasis across the desert. Now we realize it was just a mirage. We are nowhere near salvation, and the markets have just woken up to this fact," he said.
What the Financial Crisis Means for Germany
by David Böcking - Spiegel
Germany has been enjoying the biggest economic boom in a generation, shrugging off the debt crisis raging in several of its trading partners. But the prospect of a double-dip recession in the US could put a stop to that.
One of the most common catchphrases in the consulting business is that there are opportunities to be found in every crisis. The global financial crisis of 2008 indeed provided the German economy with the chance to shine. German businesses enjoyed stronger growth than most rivals once the worst of the crisis was over. Germany emerged as a world champion of the economic rebound.
But is the worst truly over? With its downgrading of the United States' top credit rating on Friday, Standard & Poor's triggered fears that we may be facing a double-dip recession.
Up until now, Germany has appeared to be largely immune from the economic problems plaguing other countries. Whereas southern Europe and the US appeared to plunge from the financial crisis almost directly into the debt crisis, Germans enjoyed record economic growth. Will that continue to be the case if other economies elsewhere slide back into recession?
A double-dip recession could affect Germany in two ways:
- as an exporting nation selling goods to crisis-afflicted countries
- and as a credit guarantor for other euro-zone countries hit by the crisis
A number of indicators have suggested in recent weeks that the German economic boom is winding down , even before the latest escalation of the debt crisis. In June, German industry sales stagnated, according to the latest statistics, with foreign demand falling by 0.1 percent. Germany's engineering sector, a particularly strong and important part of the economy, showed growth of only 1 percent in June according to industry association VDMA. Meanwhile, the most recent purchasing manager's index showed declines in demand for German products in a number of countries.
Ralph Wiechers, chief economist at the VDMA, says the current slowdown in German industry is attributable mainly to the winding down of catch-up investments -- expenditures that had been postponed during the crisis and resumed once it ended. But Wiechers said he would not rule out a further worsening of the situation, either. "The unresolved dollar and euro crisis is an economic risk and thus also a potential burden for our businesses."
One concern is that interest rates could rise in response to the downgrading of the US credit rating. If that were to happen, American consumers and companies would likely invest less, meaning also that less money would flow to Germany as a trading partner.
Germany Less Vulnerable to the US
But the US is a significantly less important market for German products than it used to be. "In the 1970s, up to 14 percent of German exports went to the US, whereas it was just 6.8 percent in 2010," said Michael Pfeifer, head of state-owned economic agency Germany Trade and Invest (GTAI). The strong recovery of the German economy was driven less by the US than by emerging economies. Germany has benefited from its focus on the kind of machinery that countries such as China and Brazil need to expand their economies.
"German experts are diversified, which makes us less vulnerable than we were a few years ago," said Ansgar Belke, an analyst at Berlin's German Institute for Economic Research (DIW). Nevertheless, the US remains the biggest foreign investor in Germany. According to GTAI, more than a quarter of direct investment ventures since 2003 have been made by US companies. And US firms employ almost 750,000 people in Germany. In May, more than half of firms polled by the American Chamber of Commerce in Germany said they planned to hire more workers in 2011.
While Germany could cope with a slight weakening of US demand, a real double-dip recession in the world's largest economy would pull Germany down with it. "In the long term, it's impossible to decouple from the US economy," said DIW economist Belke.
A further problem is that other engines of growth may be about to start sputtering. Emerging markets are struggling to stop their economies from overheating and there are fears that a real estate bubble may be about to burst in China. The economies are likely to keep on growing, but they won't be unscathed by the turmoil in financial markets. On Monday, Latin American stocks were heading for their largest losses in over a year.
Strong Euro, Weak Euro Partners
In addition, Germany's European partners may be about to suffer slowing growth, which is bad news for Germany in two ways: firstly, it endangers the country's most important sales market. In June, just under 42 percent of German exports went to euro-zone countries, and 61 percent went to nations in the wider European Union.
Secondly, it could force Germany to devote further billions to shoring up over-indebted euro-zone member states. It already shoulders around €120 billion of the euro bailout fund's €440 billion. If the fund is enlarged, Germany's share will grow commensurately.
The borrowing costs of Italy and Spain fell on Monday after the European Central Bank started purchasing government bonds issued by those countries. But DIW economist Belke believes that the euro will remain strong because of the US crisis. "That is bad for the peripheral countries," he says -- a strong euro makes it hard for those countries to export goods and attract foreign investment.
It would be particularly unpleasant for Germany if speculation about a ratings downgrade for France were to come true. The French are the biggest buyers of German products, with annual imports exceeding €90 billion. France is also the second biggest contributor to the EU bailout fund.
If France were to require help itself, these guarantees would vanish, and Germany would probably have to provide much higher guarantees than at present. Standard & Poor's last week confirmed its top AAA rating for France at the end of last week. But price increases for credit default swaps on French government bonds on Monday showed that some investors are starting to speculate against the second-biggest economy of the euro zone.
For the time being, Germany itself looks safe from attacks by speculators. The country is benefiting from its reputation as a safe haven, and thanks to its membership of the euro, it is avoiding the currency surge that safe-haven buying usually entails. Switzerland, by contrast, is laboring under a sharp appreciation of the franc.
And because the yields on German government bonds have fallen to new lows in recent days, the country can borrow money even more cheaply now -- while other nations struggle to obtain new loans at prohibitive rates.
Call to Downsize Giants of Ratings
by Jeannette Neumann - Wall Street Journal
Three weeks ago, Egan-Jones Ratings Co. downgraded America. Almost no one paid attention. "S&P's downgrade was on the front page of every newspaper," said Sean Egan, president of the Haverford, Pa., ratings firm, which has been issuing ratings since 1995.
Mr. Egan's disappointment that Standard & Poor's rattled the world with its Friday-night rating cut on long-term U.S. government debt to double-A-plus, from triple-A, while his identical move was essentially ignored, is a sign of the grip on the debt-ratings industry held by its three giants.
McGraw-Hill Cos.' S&P unit, Moody's Corp.'s Moody's Investors Service unit and Fitch Ratings, a unit of French company Fimalac SA, have about 2.7 million ratings on corporate, municipal, sovereign and other types of debt, according to securities filings. The seven other ratings firms overseen by the Securities and Exchange Commission have around 82,000 ratings.
The three biggest credit-ratings firms have "been given a monopoly," Mohamed El-Erian, chief executive and co-chief investment officer of Pacific Investment Management Co., said in an interview last week, before S&P's downgrade. "Whether we like it or not, the rating agencies are hard-wired into the system."
Criticism of the industry's dominance heightened following S&P's downgrade, especially after the company went ahead with the downgrade after U.S. officials said they noticed a $2 trillion error in S&P's calculations. The mess is fueling an unusual consensus among Democrats and Republicans that more competition might be needed in order to limit the impact of any single firm's ratings moves on financial markets.
S&P, Moody's and Fitch have a U.S. market share of about 95%, based on spending by issuers that pay the firms to rate their debt, estimates Peter Appert, an analyst at Piper Jaffray & Co. Their dominance of the business didn't change after they lost some credibility for being overly optimistic about the performance of thousands of mortgage-related bonds before and during the financial crisis. Many investors still are furious, but no other ratings firm can come close to matching the number of analysts, broad coverage and decades of experience.
Moody's got into the credit-rating business in 1909, followed by S&P in 1923 and Fitch in 1927. The oldest ratings firm, A.M. Best Co., began issuing ratings in 1907 but specializes in insurers. For decades, the industry was loosely overseen by regulators. SEC officials took over in 2007 after Congress passed a law partly aimed at encouraging more competition. Even existing rating firms had to win approval from the SEC to become so-called nationally recognized statistical rating organizations.
Pension plans, mutual funds and other large investors often have mandates to buy securities with ratings from one or more of the 10 firms registered with the SEC. The list also includes Egan-Jones, Kroll Bond Rating Agency Inc. and Morningstar Credit Ratings LLC, a unit of Morningstar Inc. Some critics of the three giants claim tighter regulation made it even harder to ignore those firms when they put triple-A ratings on collateralized debt obligations and other securities spawned by the housing boom. "The SEC protected the structured-finance business of the Big Three all the way into the subprime crisis," said James H. Gellert, chairman and chief executive of Rapid Ratings International Inc.
The New York firm issues bond ratings but decided not to seek SEC approval because of compliance and administrative costs. Since Rapid Ratings isn't overseen by the U.S. government, that means some financial players can't make investment decisions based solely on the firm's ratings, potentially limiting the market for its ratings. Proposed regulation, however, is seeking to change that. "It is important to remember that all rating agencies are not the same, and each must be judged on its own merits," a Fitch spokesman said in a statement. "Markets benefit from a diversity of credit opinions."
A Moody's spokesman said the firm believes "that the market benefits from healthy competition based on analytical quality and a diversity of credit opinions, and we support efforts to promote that diversity, whether through credit ratings or alternative means of measuring risk." A spokesman for S&P said the firm welcomes "competition because we think the market benefits from a variety of opinions on credit risk," adding that "we believe investors continue to find value in the transparency and comparability of our ratings and the quality of our research."
As a result of last year's Dodd-Frank financial-overhaul law, the SEC has proposed rules that would require rating firms to disclose more information on the accuracy of their ratings and how they decide them. SEC spokesman John Nester said those details will help investors compare firms, enhancing competition.
But Toronto-based DBRS Ltd., said it is worried that the costs of complying with tougher disclosures if the rules go through could discourage upstarts from seeking SEC approval. "I don't think competition has changed at all," said Mary Keogh, DBRS's managing director of global regulatory affairs. Mr. Nester, the SEC spokesman, declined to comment on costs triggered by the agency's oversight. The SEC isn't currently reviewing any applications for approval to become nationally recognized statistical rating organizations.
Dodd-Frank also requires U.S. regulators to purge references to ratings by one of the 10 SEC-approved firms from their rules. If approved, the move might encourage bond issuers to seek ratings from smaller firms and prod investors to pay more attention to them. "There is no need for a charmed circle of 'Here are the guys we are going to rely on,' said Lawrence J. White, an economics professor at New York University.
McGraw-Hill shares fell 1.5% on Tuesday. Some investors last week revealed increased stakes in the company, potentially heralding a push to break up the conglomerate. S&P's downgrade and this week's tumultuous markets haven't affected an ongoing strategic review by McGraw-Hill, said a person familiar with the matter. Employees at S&P headquarters in lower Manhattan got a reminder around noon Tuesday about the furor swirling around the ratings firm. A small plane flew by the skyscraper, towing a banner that said: "THANKS FOR THE DOWNGRADE. YOU SHOULD ALL BE FIRED."
Debt-Stress Gauge Shifts to Core Zone
by Art Patnaude
There has been a steady shift in the European sovereign credit-default swap market over the past month as concerns have shifted to include the core euro-zone countries as well as those on the periphery.
The price of Germany's five-year credit-default swap, briefly overtook the U.K. for the first time Tuesday, while France's CDS now trades close to double that of Germany's. CDS are derivatives that function like a default insurance contract for debt. If a borrower defaults, the contract dictates sellers compensate buyers.
The moves haven't been a knee-jerk reaction to the recent capitulation in the financial markets over the past few days, although the stock-market plunge has certainly quickened the upward trend. Whereas the U.K.'s five-year CDS is now about a third wider from the beginning of July, Germany's has more than doubled over the same period.
Germany's five-year CDS was at 0.83 percentage point Tuesday, which means it now costs an average of $83,000 a year to insure $10 million of debt issued by the country, according to data-provider Markit. This for a time surpassed the level for the U.K., a first for the CDS market. At the start of July, Germany's five-year CDS was at 0.40 point, while France traded at 0.79 point. At the close of the trading day, the U.K. was at the same level as Germany at 0.83 point.
The thrust behind the recent climb started when market participants began in early July to circle Italy and Spain, the two largest "peripheral" economies on the geographical edge of Europe, which also includes the three countries that have already received international bailouts—Greece, Ireland and Portugal. The concern was how these two countries would, if necessary, receive financial assistance should their funding costs become unsustainable. They are both widely viewed as "too big to fail."
While the rise in core European sovereign CDS has been steady since the start of July, it was the Standard & Poor's credit rating downgrade of the U.S. that helped move them into the spotlight. "The thinking is if the U.S. can be downgraded, then the likes of the U.K. and France could be next in the firing line," said ING NV rates strategist Padhraic Garvey in a note. The most-recent assistance for the peripheral countries came from the European Central Bank, which during the past two trading sessions bought Italian, Spanish and Irish government bonds to help bring down their yields.
This "puts the ECB on the hooks, in which all the euro zone states are a shareholder," said rates strategists at Société Générale SA in a note by Ciaran O'Hagan. However, the powers of the European Financial Stability Facility—the euro- zone's temporary sovereign bailout fund—could be increased if new policies are passed in national parliaments by the end of September.
"The EFSF will take over from the ECB once national parliaments have approved the new powers to the EFSF," said Tobias Blattner, analyst at Daiwa Capital Markets. Given the current size of the fund, and what might yet be needed to larger bailouts, "we are likely to see yet another discussion on an increase in the lending size of the EFSF in the months to come."
Quickly resolving this discussion is the subject of debate. There is, in addition, a potential fly in the ointment, as Mr. Garvey explains. "EFSF issuance adds directly to debt/GDP ratios, which raises the stakes for all euro zone triple-A rated issuers that underwrite with liquidity guarantees," he said. Such a change, if implemented, would mean core countries would be saddled with even more responsibility for the periphery in the long run
UK house price falls wipe £250 billion off homeowners' wealth
by Ian Cowie - Telegraph
House prices are still falling, the Royal Institute of Chartered Surveyors (RICs) reports today, wiping a total of £250bn off homeowners’ wealth since the beginning of the credit crisis, according to the Council of Mortgage Lenders (CML).
But the good news is that most homebuyers are better placed to ride out the storm in the property market now than they were during the last housing slump – and only half as many have fallen into negative equity as did then. More than a fifth of the surveyors questioned by RICs said house prices were lower last month than in the one before, with 7pc of the sample reporting fewer properties for sale in July and only 5pc noting an increase in inquiries from potential buyers. Spokesman Ian Perry commented: "The housing market continued to stall during July; prices edged lower and sales levels remained subdued."
But the CML says lower interest rates and fewer redundancies than those seen 20 years ago look set to enable more homebuyers to maintain mortgage payments and hang onto the roof over their head. It calculates that 827,000 homebuyers – or about 8pc of the total – currently have mortgage debts exceeding the market value of their home, compared to more than 1.6m in this position during the early 1990s housing slump.
While lenders claim there is no causal connection between negative equity and mortgage payment problems, fears about throwing good money after bad may well have contributed to soaring arrears and a total of 78,000 homes being repossessed in 1991.
But experts who can remember just how bad things were then argue the outlook is much better today. Ed Mead, a director of Douglas & Gordon estate agents, explained there are two reasons to expect fewer people to become overwhelmed by their debts during the current credit crisis: "One is old fashioned and good – that is, people are paying down mortgages – the other less so and purely due to low interest rates leading to less acquired debt, as there’s been no increase in mortgage payments and a gentler fall in values."
CML calculations suggest nearly half of all homebuyers have an ‘equity cushion’ of 30pc – because the market price of their property exceeds their mortgage by that much – and these borrowers’ wealth still exceeds their debts by a total of £800bn, even after house price falls since 2007.
David Hollingworth of London & Country mortgage brokers said: "The research helps paint a picture of where homeowners find themselves following the turbulence of the last few years. "Overall, many will still have substantial amounts of equity in their homes, which means they can take advantage of the best deals in the marketplace. Of course that’s not the story across the board and there’s still a number that will have quite the opposite experience having little or no options due to their negative equity."
While others continue to predict a house price crash, Melanie Bien of mortgage broker Private Finance forecasts a less dramatic outcome: "Evidence suggests that property prices are holding up better during this recession than in the 1990s, while the market has not been flooded with repossessed homes sold at knockdown prices.
"Indeed, buyers and sellers alike are sitting on their hands and adopting a ‘wait and see’ attitude. While this would have been prohibitively expensive in the early 1990s, now it is affordable." Of course, that reassuring outlook depends on interest rates and unemployment remaining subdued. But, despite all the economic doom and gloom elsewhere, homebuyers can take some comfort from the fact that things are not as bad as they used to be 20 years ago.
Worst 40-Year Bond Sale Shows Cash King as Investors Flinch: Japan Credit
by Yoshiaki Nohara and Monami Yui - Bloomberg
The worst demand on record for 40- year Japanese bonds sold yesterday signals growing concern about Japan’s ability to service the world’s biggest debt pile and the risk of holding long-term securities while markets are volatile.
The 400 billion yen ($5.2 billion) sale drew bids valued at 2.03 times the amount on offer, the weakest since the Ministry of Finance began selling the securities in 2007. The result caused bonds to reverse gains that sent the yield on the 10-year to the lowest all year. Ten-year debt yields 1.04 percent in Japan, the lowest in the world, and compared with 2.35 percent in the U.S. and 2.27 percent in Germany.
Japanese bonds and the yen have surged as Standard & Poor’s downgrade of the U.S. and Europe’s lingering debt crisis spurred a global sell-off in risky assets. Yesterday’s auction signals Japan’s super long-term bonds may have been overbought, as the nation must still find a way to reduce a debt burden that’s twice as big as its annual economic output.
"It’s hard to hold longer-dated bonds when a risk-averse environment spreads across the world," said Toru Suehiro, a market analyst in Tokyo at Mizuho Securities Co., one of the 25 primary dealers obliged to bid at the government’s debt sales. "Investors have been pretty cautious about the long-end zone because of the likelihood Japan’s credit rating will be cut after America’s downgrade, while they find short-term notes safer. That led to the bad result at the 40-year bond auction.
Japan introduced 40-year bonds in November 2007, locking in long-term borrowing costs as government debt jumped. The Ministry of Finance plans to sell a record 1.6 trillion yen of the securities in the year ending March 31, 2012, according to the agency’s web site.
Global Bond Surge
The market value of Bank of America Merrill Lynch’s Global Broad Market Index has increased $132.4 billion since the end of July to $42.1 trillion as of Aug. 8, the most in data going back to 1996. The index, containing more than 19,000 bonds sold by governments, banks and the world’s biggest companies, returned 1.09 percent this month as a stock rout on Aug. 8 wiped out about $2.5 trillion in global equity values, extending total losses since July 26 to $7.8 trillion.
The Chicago Board Options Exchange SPX Volatility Index, the VIX, surged to 48 on Aug. 8, the highest since May 2010. The benchmark for U.S. stock options is known as Wall Street’s fear gauge because it typically increases as stocks fall. The yield on the 2.2 percent bond maturing in March 2051 jumped 15 basis points to 2.335 percent as of 5:07 p.m. in Tokyo at Japan Bond Trading Co., the nation’s largest interdealer debt broker. The price slid 3.16 yen to 97.21 yen. Ten-year yields increased 2.5 basis points on the day after earlier falling to 0.975 percent, the least since November.
The average yield at the sale was 2.32 percent, the highest since a 2.3 percent rate at the January 2010 auction. A Bloomberg News survey of 13 traders before the result indicated that the highest-accepted yield would be 2.24 percent.
"It’s scary when you look at the auction’s results," said Satoshi Yamada, who helps oversee about $13 billion as manager of fixed-income trading at Okasan Asset Management Co. in Tokyo. "You can keep the securities until they mature if yields are high enough, but they’re not at the level where you can comfortably hold on to them. Investors will avoid this zone when volatility rises and they try to reduce risk."
S&P said the credit worthiness of the U.S. was diminished when it cut its rating to AA+ from AAA on Aug. 5. The company downgraded Japan in January for the first time since 2002, reducing the ranking to AA- from AA. Moody’s Investors Service and Fitch Ratings said in May they may also cut their ratings on Japan.
Group of Seven ministers and central bank governors pledged in a statement this week to "take all necessary measures to support financial stability and growth." The European Central Bank said in a statement it will "actively implement" its bond-purchase program, and has purchased Italian and Spanish bonds to curb a surge in yields.
Of Japan’s 880 trillion yen of debt, 3.6 trillion yen of it is in 40-year bonds, Bloomberg data show. The nation’s four biggest life insurers said in April they’ll focus investments on longer-term bonds this fiscal year. "Thirty- and 40-year bonds have been so strong that the government decided to increase the amount of issuance this year for those terms," Mizuho Securities’ Suehiro said. "But if demand remains weak as we see, Japan may need to rely on shorter-term bonds."
Japan’s Ministry of Finance said that every 1 percentage- point increase in 10-year yields above 2 percent would add 1 trillion yen in debt-servicing costs to a projection of 22.9 trillion yen for the fiscal year starting April 2012. The nation’s total debt may reach 219 percent of gross domestic product next year, according to the Organization for Economic Cooperation and Development.
Data this week showed that China sold Japan’s medium- and long-term debt for the first time in nine months in June. China sold a net 508.5 billion yen of the fixed-income securities in June, according to data by Japan’s Ministry of Finance in Tokyo released on Aug. 8. China was a net seller of 8.4 billion yen in short-term notes maturing in less than a year.
The yen advanced 1.2 percent against the dollar in June and 5 percent last month. The currency touched 76.30 per dollar on Aug. 1, near its record 76.25 reached in March and prompting Japan to unilaterally sell the yen three days later.
Dylan Ratigan gets mad