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3 CREDIT BUBBLE
BULLETIN The dog that's not
barking Commentary and weekly
watch by Doug Noland
The rally prompted
by "go ahead, make my day" Mario Draghi, the
European Central Bank president, who "will do
everything to save the euro" saw Spanish and
Italian stocks jump 10.6% and 9.5%, respectively,
in six sessions. The S&P500 rose 2.0%, with
the Goldman Sachs "Most Short" index surging 7.4%
(in six
sessions). Spain's two-year
yields sank 160 basis points (bps) in four
sessions and Italy's fell 100 bps. Crude, gold and
commodities popped.
Somewhat the dog that
didn't bark, the euro, closed on Friday at 1.2252,
up little since Draghi's comments and only about
2% above recent trading lows. Spain's 10-year
yields ended last week at a problematic 6.85% and,
at 5.88%, Italy's 10-year yields were only
somewhat less discouraging.
There appears
to be a meaningful shift in market thinking
regarding global monetary stimulus. Recent events
have further (it that's possible) emboldened those
believing that policymakers will do everything to
backstop global risk markets. To be sure, the
"risk on, risk off" dynamic has become only more
dominant.
Draghi's plan may have done
little to bolster the euro, but it did incite
another powerful "rip your face off" short squeeze
in many risk markets. Policymakers may very well
take satisfaction in wielding such extraordinary
market power, although there will be a heavy price
to be paid for interventions that feed
increasingly unwieldy markets. And, by the way,
it's also apparent that monetary policy is having
a waning effect on real economies.
Actually, it's no coincidence that
policymaking takes an increasingly commanding role
in global markets even as policy measures show
diminished economic impact. That's a fundamental
bullish tenet of the "risk on, risk off"
speculation phenomenon: the greater the economic
and systemic risks, the more powerful the policy
liquidity response available to stoke global risk
markets. Market participants grapple with the
question of how long this game will continue
working so well.
Data out of China this
week was unimpressive. Bank lending slowed sharply
from June (to US$85 billion from $150 billion).
Weakness was apparent in industrial production,
retail sales and housing transaction volumes. Most
alarming was the sharp slowdown in exports. At a
positive 1% year-over-year, July export growth
sank from June's 11% and was significantly below
expectations of 8%. And with exports to Europe
down 16%, this data point is one of the clearest
indications yet of how the rapidly deteriorating
European situation is hitting China. An article
from Friday's Wall Street Journal, "Trade Slowdown
Squeezes Asia", did a commendable job of
describing how "the slowdown under way in China is
already rippling across Asia ... "
There's
a common perception in the marketplace that
Chinese authorities can flick a switch and reflate
their economic boom on command. I have tried to
make the case that China - and "developing"
economies more generally - are in an altogether
different circumstance these days than they were
back in 2008/9 (fragile instead of robust, from a
credit bubble perspective). Importantly, these
credit systems and economies were previously
enjoying robust inflationary biases.
As
such, "developing" systems proved extraordinarily
responsive to stimulus measures - and were
well-positioned to assume the desperately needed
role of global locomotive coming out of the '08
crisis-induced global recession. I see only added
support for the view that "developing" financial
and economic fragility will be one of the big
surprises unearthed by the unfolding "European"
crisis.
Especially in China, as the
downturn gathers momentum, markets confidently
anticipate aggressive stimulus measures. A
Bloomberg headline captured the sanguine mood:
"Slide in China's Export Growth Increases Odds of
More Stimulus." Deteriorating economic
fundamentals have been the first surprise to the
bullish consensus view, and a tepid response to
stimulus measures will likely prove the second.
The impotence of post-bubble stimulus
measures remains solidly on display here in the US
I have not been as bearish as others on near-term
US economic prospects. Yet it's ominous that zero
interest rates, the nationalization of mortgage
credit, massive Federal Reserve monetization and
market interventions, and 8-10% annual fiscal
deficits equate to such a feeble recovery.
Throughout Europe, things proceed
methodically from bad to worse. Spanish and
Italian economic data, in particular, continue to
be depressing. Meanwhile, it is increasingly
apparent that the German economic juggernaut is
showing the region's ill-effects. Market
participants pay little attention to the data,
though, as they now wait anxiously for the
unveiling of the game-changing Draghi plan. Many
anticipate the positive impact a new liquidity
push could have on securities prices, although few
expect much help for the real economies.
But the cautious consensus view believes
that the Draghi plan at least protects against
"tail risk." Cleverly, the ECB bought a few weeks
by assigning details of the plan to various
committees. This was sufficient to run the bears,
reverse risk hedges and, again, run things amuck
for so-called "market neutral" trading strategies.
And especially now that Germany's Angela Merkel
government is viewed as having capitulated, Draghi
is thought to enjoy a window to pursue more
open-ended Fed-like quantitative easing.
Moreover, with an isolated Germany holding
only one vote in a new-found, majority-rules ECB,
the hope is that the Draghi ECB can finally move
decisively toward assuming the role of buyer of
last resort for European (for now, chiefly Spanish
and Italian) debt.
The Draghi plan could
very well support European debt markets. Yet I
really struggle with the notion of the ECB as
savior for the euro. Desperate central banks are
easily more apt to hurt rather than help their
currencies. In a crisis environment, a central
bank often must choose between flooding a system
with liquidity to bolster debt and asset markets -
or instead restrain liquidity creation in hope of
stemming capital flight and stabilizing the value
of its currency.
Draghi would like to
tough talk both securities markets and the euro
higher, but European policymaking credibility is
badly depleted. So markets will force his hand
into coming with a substantial bond-buying
strategy. Such a plan risks liquidity abundance
fanning problematic capital flight.
And
this gets back to the dog that's not barking. The
euro has thus far struggled to retreat from the
precipice. I have speculated that there are likely
huge derivative trades written to provide
protection in the event of a major euro decline.
It's reasonable that significant "insurance" has
been written at the 1.20, 1.15 and 1.10 (to the
dollar) strikes. If correct, this analysis infers
that potentially enormous selling pressure might
be unleashed if the euro falls much below current
levels.
European economies are spiraling
downward, and I expect economic activity to remain
largely impervious to monetary stimulus. I don't
believe the Draghi plan will reverse the crisis of
confidence in eurozone debt or the European
banking system - or meaningfully loosen credit
conditions. And, as I mentioned above, I fear a
desperate ECB may increasingly jeopardize the euro
(see Otmar Issing's comments below). Draghi
invoked "convertibility risk" as justification for
monetizing government borrowings. Such measures,
however, will not allay market fears regarding the
sustainability of the euro currency. Increasingly
destabilizing capital flight remains a serious
risk.
Interestingly, former Bundesbank and
ECB chief economist Issing maintained a
high-profile last week. He was interviewed by Dow
Jones/The Wall Street Journal, and then appeared
live on CNBC. He said little that markets would
find comforting, although participants to this
point have been dismissive of his influence. This
week only added to my suspicions that Issing and
some of the old guard from the Bundesbank may feel
the situation has deteriorated to the point that
they must become part of the debate.
From
the Wall Street Journal (8/9/12 - Christian
Grimm): "Mr Issing said that from a historical
perspective Germany indeed is 'in a special
position' but 67 years after the war ended
'Germany can't be blackmailed with its past,' he
said. This is especially true of aid for troubled
euro zone states, 'which does not solve the
problems in these states ... ' Mr Issing said it
was wrong to expect the European Central Bank,
tasked primarily with maintaining price stability
in the euro zone, to step into the breach and buy
the bonds of troubled euro zone states. 'This does
not solve the problems and is not legitimate,' he
said, adding that it violates EU treaties ... Mr.
Issing rejected the idea that any country could
stay in the euro zone at any price. This 'creates
the possibility of blackmail. The participation in
the shared currency must be permanently earned,'
he said."
And from Issing's forthcoming
book: "The less politicians address the root of
the problems, the more they look with their
expectations and demands to the ECB, which is not
made for this. It is a central bank and not an
institution to rescue governments threatened by
bankruptcy. A central bank always also acts as a
lender of last resort for the banking system - but
it does not rescue governments."
From CNBC
(8/10/12 - Silvia Wadhwa and Catherine Boyle): "'A
break up of the euro area would be a major
disaster - no doubt about that. But the
alternative to that, [is] being a monetary union
in which the reputation of the ECB would be
undermined, or even destroyed. The euro would
tumble and governments would pile up debts without
any limit. I think this is a scenario - a horror
scenario - which comes close to the disaster of a
break up ... The euro itself does not need to be
saved. What has to be saved is the stability of
the euro and the euro area. The question - how
many countries can participate, this is the
challenge with which Europe is confronted,' Issing
said ... Politicians who blame German Chancellor
Angela Merkel for creating turmoil in the markets
by not taking further action on issues like
Eurobonds should 'shut up,' Issing said. 'They
(politicians) always give the impression that they
have the right medicine, which is more money, and
markets will always ask for more. So this will be
an endless game and politics will always be seen
as prisoners of this process. It should be
reversed. Politics should say what will not
happen. This total mutualization of debt - this is
something which must not happen,' Issing added."
WEEKLY WATCH The S&P500
gained 1.1% (up 11.8% y-t-d), and the Dow rose
0.90% (up 8.1%). The Morgan Stanley Cyclicals
jumped 3.3% (up 8.1%), while the Transports
slipped 0.5% (up 0.9%). The Morgan Stanley
Consumer index increased 0.8% (up 7.2%), while the
Utilities fell 1.1% (up 3.3%). The Banks were up
1.2% (up 18.4%), and the Broker/Dealers rallied
2.1% (down 3.8%). The S&P 400 Mid-Caps gained
1.8% (up 9.4%), and the small cap Russell 2000
rose 1.7% (up 8.2%). The Nasdaq100 was 1.8% higher
(up 19.5%), and the Morgan Stanley High Tech index
jumped 3.3% (up 15.7%). The Semiconductors surged
4.1% (up 11.4%). The InteractiveWeek Internet
index gained 2.2% (up 10.8%). The Biotechs rose
0.9% (up 32.2%). With bullion rising $17, the HUI
gold index rallied 5.6% (down 13.8%).
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