ECB Considers Interest Rate Caps; Can Such a Scheme Possibly Work?

Monday, August 20th, 2012

by Michael ‘Mish’ Shedlock, Global Economic Analysis

Economic Times reports European Central Bank mulls caps on borrowing costs

The European Central Bank is considering buying the bonds of crisis-wracked eurozone countries to ensure borrowing costs do not rise beyond a pre-determined level, German newsweekly Der Spiegel said Sunday.

The bank will define an upper limit for borrowing costs in countries such as Spain and Italy and intervene in the markets to ensure it is not breached, Spiegel said, without citing its sources.

At the end of trade on Friday, Spain was paying 6.39 per cent to borrow for 10 years and Italy 5.76 per cent. In contrast, Germany was paying 1.49 per cent, as investors trust Europe’s top economy to repay them.

The so-called spread, or difference, between benchmark German bonds and the debt-wracked countries would be decisive for the proposed rate cap, Spiegel said.

ECB President Mario Draghi announced earlier in August that his institution “may” buy bonds of struggling countries if they first apply for EU bailout funds and accept tough conditions in return.

He said the details would be worked out before the next meeting of the ECB, scheduled for September 6. Spiegel said that ECB governors would decide then whether to implement the proposed borrowing cost cap.

Here is a link to a translated article in Der Spiegel: ECB is planning to challenge interest rate speculation

The European Central Bank (ECB) is considering to establish in its future bond purchases interest rate levels for each country. Thus, they would state papers of the crisis countries always buy when interest rates exceed a certain impact on their yields German Bunds. Sun investors would get a signal that interest rates, the ECB considers appropriate.

Because the Fed has unlimited funds – they can even print the money eventually – it would not succeed even more speculators to drive the returns of the targeted rate also. Thus, the ECB wants to keep not only the financial costs of ailing countries in check, but also to ensure that the general level of interest rates in the euro zone is not too much drifting apart.

At its next meeting in early September, the Governing Council will decide whether the interest rate target is actually installed. One thing is certain, that the ECB will continue to practice their bond purchases more transparent. In the future, they will announce each country, in which capacity she has taken the bonds from the market. This information should be released immediately after the purchases. So far, the ECB had only ever made known Monday how much money she spent on purchases in the previous week as a whole.

Can This Work?

It depends on the definition of “work”. In general, if central planners (and it is important to understand that is what we are talking about here) set prices too high there will be unlimited supply.

Likewise, if central planners set prices too low, there will be shortages.

When it comes to money, recall that Switzerland capped the rate of the Swiss Franc vs. the euro. To defend that cap the Swiss National Bank has to offer unlimited money at the target exchange rate.

When it comes to interest rates, the ECB must be willing to buy an unlimited number of bonds (up to the total supply of all bonds).

Theory vs. Practice

So yes, the ECB can “in theory” defend a price target on bonds, but only at the risk of owning every bond.

What about an exit mechanism? How will the ECB get rid of all those bonds down the road? To who, at what price?

Will Germany go along with this ridiculous scheme? For how long?

As is always the case, interference in the free market by central planning fools always fails in the long run.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

Tags: Article In Der Spiegel, Bailout, Borrowing Cost, Crisis Countries, Ecb President, Economic Times, German Bonds, Global Economic Analysis, Governors, India, Interest Rate Caps, interest rates, Investors, Mario Draghi, Michael Mish, Mish Shedlock, Rate Cap, Speculation, Speculators, Spiegel
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U.S. Equity Market Radar (July 2, 2012)

Monday, July 2nd, 2012

U.S. Equity Market Radar (July 2, 2012)

The S&P 500 Index rose 2.03 percent this week on the back of a huge rally on Friday. Two noteworthy events this week included the Supreme Court ruling on healthcare legislation announced on Thursday, which the market negatively reacted to, and the EU Summit conclusion on Friday, which provided the market a positive surprise relative to low expectations. Key proposals of the EU Summit include the establishment of a single supervisory body for eurozone banks and the allowance for direct bailout of banks, essentially back stopping the banks and likely holding the Euro together if the details can be worked out. This was a major catalyst for the market which had become accustomed to being disappointed by European leaders.

Strengths

• The energy sector rocketed 4.8 percent higher this week as oil rose by 6.5 percent. Much of this week’s move came on Friday when crude oil rose by more than 9 percent. Stocks that had been beaten up the most tended to be the ones that rallied the most.
• The materials sector rose 2.8 percent with leadership from construction materials, steel and fertilizer names.
• Homebuilders were also among the best performers for the week as Lennar reported strong quarterly results and housing data continues to be better than expected.
• The best individual stock performer this week was Constellation Brands which rose 39.7 percent as the company bought the other half of its joint venture with Grupo Modelo, giving the company sole distribution of Modelo’s brands in the U.S. including Corona.

Weaknesses

• The technology sector lagged as tech heavyweights such as Intel, Hewlett-Packard and EBay all fell for the week.
• Retailers and related names also tended to struggle this week as disappointing earnings guidance from O’Reilly Automotive appeared to begin a negative cascade that took down several high flying stocks such as Chipotle Mexican Grill and Ross Stores.
• Managed care companies were negatively impacted by the Supreme Court ruling upholding the Affordable Care Act as Wellpoint, Coventry Health and Aetna were among this week’s worst performers.

Opportunity

• With the Fourth of July holiday in the middle of the week next week, expect muted trading activity. However, the European Central Bank is expected to cut interest rates on July 5 and unemployment data will be released next Friday.

Threat

• Europe positively surprised the market this week but the threat remains that the EU Summit proposals will be unable to be implemented in a timely fashion.

Tags: Bailout, Chipotle Mexican Grill, Constellation Brands, Ebay, energy sector, European Leaders, Grupo Modelo, Healthcare Legislation, Heavyweights, Low Expectations, Market Radar, Materials Sector, Noteworthy Events, O Reilly, Quarterly Results, Reilly Automotive, Ross Stores, Sole Distribution, Supervisory Body, Supreme Court Ruling
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Energy and Natural Resources Markets Radar (July 2, 2012)

Monday, July 2nd, 2012

Energy and Natural Resources Market Radar (July 2, 2012)

Strengths

• In reaction to an insurance embargo on Iranian oil vessels, effective this Sunday, South Korea will halt all oil imports from Iran. These vessels rely on insurance to protect them against any accidents they may encounter, and most companies that provide this type of insurance are based in the EU. South Korea, Iran’s fourth largest oil consumer, is currently in talks with countries such as Iraq, Kuwait, Qatar, and the United Arab Emirates to find a new route to meet their demand.
• Strikes in Norway regarding pensions and retirement age led to the closing of three more oil fields, restricting more than 15 percent of the country’s oil supply and 7 percent of its natural gas supply. Last month, Norway produced 1.63 million barrels of oil per day, and Statoil has already reported losses of up to 250,000 barrels per day. Brent Crude Oil prices saw a slight increase as a result.
• Vale received an environmental license to expand the biggest iron-ore mine in the world, estimating that about $1 trillion worth of reserves are to be found. They hope to double their iron-ore capacity at Carajas in Northern Brazil, and by 2017 hope to increase their output to 230,000 tons per year.
• Crude oil futures (West Texas Intermediate) gained nearly 6 percent this week with most of the gain on Friday following news that European leaders had agreed to allow struggling European banks to borrow directly from bailout funds.

Weaknesses

• Aluminum has dropped in value to $1,845 per ton, its lowest price since June 7, 2010. Because of these deteriorating prices, Rusal plans to curtail 8 percent of its smelting capacity by 2013. Furthermore, provincial governments in China have granted subsidies to smelters to increase aluminum production. This comes after the government faced a loss in tax revenue and higher unemployment from the reduction of output in Henan, a province that contributes 20 percent to China’s total aluminum capacity. After the news let out, aluminum prices dropped 3 percent on the Shanghai Futures Exchange.
• Arch Coal, in the midst of low natural gas prices and slowing electricity consumption, temporarily suspended mining operations across the country, resulting in 750 layoffs. SouthGobi Resources also has plans to halt its coal mining operations in Mongolia because of weak demand and an unpredictable future.

Opportunities

• Lennar Corp. is in talks and has signed a memorandum of understanding with China Development Bank Corp. regarding an approximate $1.7 billion loan. This loan would help transform two former naval bases into a $13 billion housing project and greatly benefit the timber industry.
• Within a year, Bangladesh is planning on boosting domestic natural gas supply by 63.25 percent to meet a demand that has been increasing by about 14 percent a year since 2003. Chevron and many state-owned companies have already prepared to increase supply to the country.
• In a slow diamond market, Botswana’s Minerals Minister believes the country can turn towards copper and silver, in addition to coal mining, to provide a more prominent source of revenue. This transition of focus may diminish the weight the diamond industry has on Botswana’s economy.

Threats

• Iraq’s oil output has reached a 20-year high, passing 3.07 million barrels per day for the month of June, as it seeks to overtake Iran in becoming OPEC’s second largest producer. Iraq plans on producing 70,000 barrels a day at Halfaya field during the first week of July and hopes to more than double its output by 2015. This increase in output will weigh heavily on global oil prices.
• Guatemala’s President, Otto Perez Molina, has proposed reforms to the constitution, essentially giving the government up to 40 percent ownership in mining and exploration companies in the area. Molina campaigned on increasing foreign investment, but there may be unintended consequences should these proposals be ratified.

Tags: Aluminum Production, Bailout, Brent Crude Oil, Brent Crude Oil Prices, Carajas, Crude Oil Futures, Crude Oil Prices, European Banks, European Leaders, Iranian Oil, Iron Ore, Market Radar, Northern Brazil, Oil Imports, Oil Supply, Provincial Governments, Retirement Age, Statoil, United Arab Emirates, West Texas Intermediate
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More Gruel, More Gruel (Grant)

Wednesday, June 13th, 2012

From Mark Grant, author of Out of the Box

Pathos

It is really rather pathetic. The Prime Minister of Spain today called for a deposit guarantee fund, pleaded for the EU to take over the budget of Spain and said Spain would cede its sovereignty over its banks. This is all just one thing; a cry for money and money at any cost. The poor fellow has obviously lost whatever self-respect that he had and is behaving no differently than some street urchin begging for alms. What can be seen from this kind of behavior is the desperate state that Spain is in and it is reflected in his desperate pleas for help. I would speculate that so much has been hidden and so many balance sheets falsified that Spain has suddenly found itself in a sea of their own making which could be termed, “Dire Straits.” When Rajoy termed the bailout for Spain as a “Victory for Europe” I knew that he had left “sense and sensibility” behind and headed into the land of Don Quixote where windmills were imagined to be giants and fantasy had replaced reality. The problem is, unlike the creation of Miguel Cervantes, this guy is the Prime Minister of Spain and not some aged senior chasing after the Knights Templar in his later years.

More Gruel Please Sir

I am reminded of that famous scene in Oliver where a second serving is asked for and the commotion that it causes. The European Union can now be viewed as three distinct groups. The bailed-out countries that are trying to renegotiate their agreements, pleading for more money, and asking for more integration in the hopes of getting more gruel. This is all characterized by some grand plan of course so that they can con the wealthier nations out of their money under the banner of the Three Musketeers, “All for one and one for all” which really just means; “give me your money so I can live just like you do and thank you so much.” Then the second group is the Brussels Sprouts which want to take over power from all of the national governments and run Europe out of Belgium and wave flags, have parades and dine on Beluga caviar accompanied by splits of champagne. They believe their own rhetoric and think that Europe is going to be some commonality where the people in Berlin and the people in Lisbon have the exact same standard of living and I think there will be a revolution in Germany before that is allowed to happen. Then the final category is Germany, the Netherlands, Finland and Austria which everyone else wants to pay for this enterprise as Germany passes out just enough to maintain control and makes certain well defined noises to keep everyone begging for more while they refuse to partake in any of the nonsense bandied about by the poorer nations as they are not going to destroy their own economy for the sake of some grand scheme that would raise their cost of funding to an average of Europe while lowering their standard of living to a mean of Madrid and Athens; it is just not going to happen and no delusions should be maintained.

It is not that hard to figure out, this dis-jointed Europe, just watch what the Germans actually do and don’t pay too much attention to what they say; that is the trick of it. The whole thing is a double con game but the people with the money, as in the rest of life, are who is in control and not the beggars with outstretched hands hanging about on the corner. Spain has fallen, Italy is under siege and France wants to join the have-nots in the hope that Germany will pay for all of the promises made by Hollande to the French people during their election. As Italy falters France may be the next nation to come under closer inspection especially if Hollande proceeds to implement more government spending and the lowering of the retirement age along with his other Socialist programs. Again I remind you to pay little attention to the rhetoric but watch what Germany does and that will set the program for the future. They can vote all they want in Brussels and draw up all kinds of grand plans they desire but if Germany does not want to accept them then it is little more than semi-polite conversation over well-dressed cucumber sandwiches in various capital of Europe.

June 17

This is the day of the elections in Greece as Democracy rears its ungainly head. One way or another; the outcome is likely to be unsettling. If the leftist party wins then a game of chicken will ensue with Germany doing a down and dirty calculation on how much it will cost them and offering just that much and no more. Then the young leader of the new Greek government will probably overplay his hand and Germany will turn off the monetary spigot. This will then lead to a second game of chicken where Germany tries to get Greece to leave as Greece dares them to throw them out. The rhetoric will get quite testy and we will all watch to see who blinks first. Greece will regain the spotlight but the cost of the performance will be high. There is $1.3 trillion riding on this bet which is the total amount of Greece’s unpaid bills and a default will cause havoc past what I think the Germans will calculate. Europe seems to believe its own jargon these days and I fully expect any EU offers to miss the mark by a wide margin and then the demons will leap from the Trojan horse.

Tags: Alms, Bailout, Brussels Sprouts, Commotion, Deposit Guarantee, Desperate Pleas, Desperate State, Dire Straits, Distinct Groups, Don Quixote, Guarantee Fund, Mark Grant, Miguel Cervantes, Poor Fellow, Prime Minister Of Spain, Second Group, Self Respect, Sense And Sensibility, Street Urchin, Three Musketeers
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Central Banks, Spanish Banks, and 2 JPM Banks

Friday, June 8th, 2012

by Peter Tchir, TF Market Advisors

Yesterday’s price action was about par for the course. Markets were higher on Chinese rate cut and that Merkel said something other than “austerity now”. Stocks dipped as Ben didn’t provide any immediate plans for QE. Then stocks rallied because no one had believed Ben was going to do much anyways. Finally, into the close, consumer credit and news that a strike might affect the timing of the Greek election helped push everything to lower on the day. It is worth noting that HY bonds and EM debt managed to close higher yesterday in spite of the late day stock slide.

Asia followed through with more weakness, and Europe has bounced up and down a little. The latest news is that there will be some sort of a call or a conference of a “virtual summit” this weekend to deal with Spanish bank recapitalizations. I doubt we see a “direct” bailout though I’m not sure the difference between direct and indirect is meaningful as others seem to think it is. If Europe follows its usual course of action, it will do something, but it won’t be enough to take the problem off the table for long. The best outcome would be to wipe out the equity and sub-debt of these banks and truly nationalize them. That would require the least amount of new money. That would likely spook the markets initially seeing equity wiped out, and all bank share prices would probably drop, but once the market figured out which banks wouldn’t need to be nationalized we would see them bounce back, followed by the market at large, because that would actually help convince people the banking problem was “solved” for longer than the usual month or two.

The global scenario remains the same, weakening economic conditions partially offset by the risk of central bank and policy intervention. Left alone the market will continue to sell off as the global economy continues to weaken. Some huge intervention in terms of liquidity or actual money printing can reverse the growth picture (at least temporarily) and spur another round of yield and risk chasing.

The “whale” story at JPM seems to be finally running its course. The daily hype around it has died down and now we are getting into the finger pointing and government soundbite stage. The complete lack of disclosure remains depressing. The fact that every investor must now realize they don’t have enough information to analyze a bank’s fair value has also hit home, yet nothing seems to be happening about that. Yet, I wonder what would happen if JPM split into an investment bank and a commercial bank. The investment bank would do all the trading, all the “sexy” business. I suspect that every good employee would want to be part of the investment bank. Ironically, for all the complaints about “risk taking” most investors would probably want to own the investment bank and not the commercial bank. The funniest thing to me would be listening to people complain that it is unfair that the investment bank went private and shareholders can’t get a piece of the action. Seriously, for all the TBTF arguments, for all the complaints about the risk JPM took, what part of the business would you want to own?

I expect a reasonably quiet, but positive day, with Europe already preoccupied by football and bears being cautious heading into the weekend with the threat of some near term quasi resolution to the Spanish banking problem. Credit is likely to outperform, particularly as investors seem comfortable with U.S. high yield once again.

Tags: Austerity, Bailout, Bonds, Central Banks, Consumer Credit, Economic Conditions, Global Economy, Global Scenario, liquidity, Merkel, New Money, Policy Intervention, Qe, Share Prices, Spanish Bank, Spanish Banks, Spite, Stock Slide, Stocks, Tf
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China Joins Global Easing Party By Cutting The Lending And Deposit Rates By 25 bps

Thursday, June 7th, 2012

Update: 9:00 am has come and gone… and no global bailout unlike November 30, 2011. Not a good sign for those expect a central-bank D-Day.

While minutes ago the Bank of England followed in the ECB’s footsteps, it was the China central bank that stole England’s thunder, announcing an unexpected rate cut moments before 7 am, and thus finally joining the global easing party: this was the first Chinese interest rate cut since 2008. As a reminder, hours before the global central bank intervention on November 30, China announced its first (50 bps) reserve requirement cut since 2008. Is today’s PBOC move, which is the first cut of deposit and 1 year lending rates also since 2008, a harbinger of something much bigger to come any second now?

From the PBOC:

The People’s Bank of China decided to cut financial institutions RMB benchmark deposit and lending interest rates since June 8, 2012. One-year benchmark deposit rate cut of 0.25 percentage points, year benchmark lending interest rate cut by 0.25 percentage points; other deposit and lending interest rates and individual housing provident fund deposit and lending rates be adjusted accordingly.

 

Since the same day: (1) the upper limit of the floating range of interest rates on deposits of financial institutions was adjusted to 1.1 times the benchmark interest rate; (2) loans from financial institutions interest rate floating range of the lower limit was adjusted to 0.8 times the benchmark interest rate.

And from Bloomberg:

China Cuts Interest Rates for First Time Since 2008

China cut interest rates for the first time since 2008, stepping up efforts to combat a deepening economic slowdown as Europe’s worsening debt crisis threatens global growth.

The benchmark one-year lending rate will drop to 6.31 percent from 6.56 percent effective tomorrow, the People’s Bank of China said on its website today. The one-year deposit rate will fall to 3.25 percent from 3.5 percent. Banks can also offer a 20 percent discount to the benchmark lending rate, the PBOC said, widening from a previous 10 percent.

European stocks and U.S. index futures extended gains as China’s move fanned optimism that policy makers around the world will do more to bolster growth. The announcement, two days before China is due to report inflation, investment and output figures, may signal that the economy is weaker than the government expected.

“This will be the beginning of a rate cut cycle and there will be at least one more reduction this year,” said Shen Jianguang, a Hong Kong-based economist with Mizuho Securities Asia Ltd. “The data to be released over the weekend must be very weak and inflation must have eased sharply.”

The MSCI All-Country World Index added 0.8 percent at 7:30 a.m. in New York. The Stoxx Europe 600 Index jumped 1.2 percent, extending yesterday’s biggest rally in six months, while the Standard & Poor’s 500 Index futures advanced 0.7 percent.

Slower Growth

The central bank last reduced benchmark interest rates in late 2008, when the government unveiled a 4 trillion yuan ($586 billion at the time) stimulus package to counter the effects of the global financial crisis. Interest rates have been unchanged since an increase in July 2011.

Industrial output in China, the world’s biggest producer of steel and cement, probably rose 9.8 percent last month from a year earlier, close to the slowest pace in three years, according to the median estimate in a Bloomberg News survey of 27 economists ahead of a National Bureau of Statistics report due June 9.

Inflation may have moderated to 3.2 percent in May from a year earlier after a 3.4 percent rate in April, a separate survey showed, the fourth month consumer prices have risen by less than the government’s 2012 target of 4 percent.

Today’s move signals policy makers are concerned that the cost of borrowing is crimping companies’ spending and holding back expansion in the world’s second-biggest economy. Three bank officials told Bloomberg News last month that the nation’s biggest banks may fall short of loan targets for the first time in at least seven years as demand for credit wanes.
Slowdown Worsening

The PBOC cut banks’ reserve requirements in November for the first time in three years, and again in February and May, to spur lending.

China’s manufacturing expanded at the slowest pace in six months in May, a government report showed on June 1, adding to signs the nation’s slowdown is worsening. A separate purchasing managers’ index from HSBC Holdings Plc and Markit Economics pointed to a seventh straight contraction, the longest stretch since the global financial crisis.

Premier Wen Jiabao and the State Council, or Cabinet, pledged last month to place greater emphasis on stabilizing growth after data showed April industrial production, new loans and exports all increased less than economists forecast. The data prompted banks including Goldman Sachs Group Inc., Morgan Stanley and Bank of America Corp. to cut their economic-growth estimates.

Slowdown Worsening

The PBOC cut banks’ reserve requirements in November for the first time in three years, and again in February and May, to spur lending.

China’s manufacturing expanded at the slowest pace in six months in May, a government report showed on June 1, adding to signs the nation’s slowdown is worsening. A separate purchasing managers’ index from HSBC Holdings Plc and Markit Economics pointed to a seventh straight contraction, the longest stretch since the global financial crisis.

Premier Wen Jiabao and the State Council, or Cabinet, pledged last month to place greater emphasis on stabilizing growth after data showed April industrial production, new loans and exports all increased less than economists forecast. The data prompted banks including Goldman Sachs Group Inc., Morgan Stanley and Bank of America Corp. to cut their economic-growth estimates.

Tags: Bailout, Bank Of China, Bank Of England, Benchmark Interest Rate, Bps, Central Bank Intervention, China, China Cuts, D Day, Debt Crisis, ECB, Economic Slowdown, Financial Institutions, Footsteps, Global Growth, Gold, Harbinger, interest rates, Pboc, Percentage Points, Provident Fund, Reminder
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What a Potential Greek Exit Means for Investors

Friday, June 1st, 2012

by Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research

Key points

• The risk of a Greek exit has increased, although the timing is uncertain.
• In the meantime, we believe more market turmoil is likely, because most of the major tools to stem the crisis have political and legal barriers.
• We prefer underweighting Europe at this time because the potential for downside risks has increased and there is the likelihood of high levels of ongoing volatility.

In national parliamentary elections on May 6^th, many Greeks swung their support away from mainstream parties and toward anti-austerity fringe parties, increasing the chance of an eventual Greek exit from the euro. This has led a lot of Schwab clients to ask some key questions—namely, if and when Greece could exit the euro, and what this would mean for investors. One word of caution before we start: It’s unusually difficult to predict a resolution to this crisis, given the number of different scenarios and political decisions involved. Here are some of the questions we’ve heard most frequently:

• When would a potential Greek exit happen?
• If Greece is small, why would a Greek exit matter?
• What does Europe need to stem contagion?
• Could the ECB re-use prior tools?
• Will the Federal Reserve of the United States act?
• What are the arguments for keeping Greece in the euro?
• What are the implications for investors?

When would a potential Greek exit happen?

Because the May election didn’t give any party the majority of the parliament, and a coalition government failed to emerge, Greeks go back to the polls on June 17. This election could create the conditions for a fast exit if austerity measures to be implemented by June 30 are outright rejected. While Greece’s next quarterly bailout funding is due August 30, observers are concerned that Greece could run out of money as soon as July, as tax collection revenues are likely coming in below expected levels.

We believe an exit in the short-term is less likely because Europe doesn’t yet appear to have mechanisms in place to deal with the aftereffects, or contagion. A Greek exit could begin to infect other countries, threatening their ability to issue debt at reasonable rates and potentially pushing them closer to an eventual exit from the eurozone, and spark a flight of capital from banks in other peripheral countries. Measures to stem contagion will likely need approval—either parliamentary or by the general public—before they can be enacted. Therefore, Europe is likely to again kick the can down the road and buy time, even if a coalition of hard anti-austerity parties forms a government in Greece.

We believe the probability of a Greek exit increases as the year progresses and over the next several years. Greece is likely to need continual relaxation of bailout targets, which will become increasingly unpalatable to the electorate in financially stronger countries.

If Greece is small, why would a Greek exit matter?

We believe that markets are focused on Greece primarily because of the risk of contagion to Spain and Italy. While even last fall there was hope that Greece’s problems could be “ring-fenced,” or contained, the risk of contagion has become increasingly apparent.

Italian and Spanish bonds move somewhat in tandem

Source: FactSet, iBoxx. As of May 29, 2012.

Spain’s problems are complicating the situation. In Spain, the fiscal deficit has been revised negatively and the health of its banking system has been deteriorating. The Spanish fiscal deterioration, combined with the inaction of the European Central Bank (ECB) at its April monetary policy meeting, helped to increase yields on the government debt of an entirely different country—Italy. Italian and Spanish government bonds continue to move somewhat in tandem, even though you could argue that Italy’s financial position is stronger than Spain’s.

Tags: Austerity Measures, Bailout, Caution, Cfa, Coalition Government, Contagion, Downside Risks, Europe Need, Federal Reserve, Greeks, Legal Barriers, Likelihood, Major Tools, Market Turmoil, National Parliamentary Elections, Observers, Political Decisions, Scenarios, Schwab, Volatility
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Eric Sprott: The Real Banking Crisis, Part II

Friday, June 1st, 2012

by Eric Sprott and David Baker, Sprott Asset Management

Here we go again. Back in July 2011 we wrote an article entitled “The Real Banking Crisis” where we discussed the increasing instability of the Eurozone banks suffering from depositor bank runs. Since that time (and two LTRO infusions and numerous bailouts later), Eurozone banks, as represented by the Euro Stoxx Banks Index, have fallen more than 50% from their July 2011 levels and are now in the midst of yet another breakdown led by the abysmal situation currently unfolding in Greece and Spain.

EURO STOXX BANKS INDEX

Source: Bloomberg

On Wednesday, May 16th, it was reported that Greek depositors withdrew as much as €1.2 billion from their local Greek banks on the preceding Monday and Tuesday alone, representing 0.75% of total deposits.¹ Reports suggest that as much as €700 million was withdrawn the week before. Greek depositors have now withdrawn €3 billion from their banking system since the country’s elections on May 6th, seemingly emptying what was left of the liquidity remaining within the Greek banking system.² According to Reuters, the Greek banks had already collectively borrowed €73.4 billion from the ECB and €54 billion from the Bank of Greece as of the end of January 2012 – which is equivalent to approximately 77% of the Greek banking system’s €165 billion in household and business deposits held at the end of March.³ The recent escalation in withdrawals has forced the Greek banks to draw on an €18 billion emergency fund (released on May 28th), which if depleted, will leave the country with a cushion of a mere €3 billion.⁴ It’s now down to the wire. Greece is essentially €21 billion away from a complete banking collapse, or alternatively, another large-scale bailout from the European Central Bank (ECB).

The way this is unfolding probably doesn’t surprise anyone, but the time it has taken for the remaining Greek depositors to withdraw their money is certainly perplexing to us. Official records suggest that the Greek banks only lost a third of their deposits between January 2010 and March 2012, which begs the question of why the Greek banks have had to borrow so much capital from the ECB in the meantime.⁵ Nonetheless, we are finally past the tipping point where Greek depositors have had enough, and the past two weeks have perfectly illustrated how quickly a determined bank run can propel a country back into crisis mode. The numbers above suggest there really isn’t much of a banking system left in Greece at all, and at this point no sane person or corporation would willingly continue to hold deposits within a Greek bank unless they had no other choice.

The fact remains that here we are, in May 2012, and Greece is right back in the exact same predicament it was in before its March 2012 bailout. Before the bailout, Greece had approximately €368 billion of debt outstanding, and its government bond yields were trading above 35%.⁶ On March 9th, the authorities arranged for private investors to forgive more than €100 billion of that debt, and launched a €130 billion rescue package that prompted Nicolas Sarkozy to exclaim that the Greek debt crisis had finally been solved.⁷ Today, a mere two months later, Greece is back up to almost €400 billion in total debt outstanding (more than it had pre-bailout), and its sovereign bond yields are back above 29%. It’s as if the March bailout never happened… and if you remember, that lauded Greek bailout back in March represented the largest sovereign restructuring in history. It is now safe to assume that that record will be surpassed in short order. It’s either that, or Greece is out of the Eurozone and back on the drachma – hence the renewed bank run among Greek depositors.

Meanwhile, in Spain, bank depositors have been pulling money out of the recently nationalized Bankia bank, which is the fourth largest bank in the country. Depositors reportedly withdrew €1 billion during the week of May 7th alone, prompting shares of Bankia to fall 29% in one day.⁸ The Bankia run coincided with Moody’s issuance of a sweeping downgrade of 16 Spanish banks, a move that was prompted over concerns related to the Spanish banks’ €300+ billion exposure to domestic real estate loans, half of which are believed to be delinquent.⁹ The Spanish authorities were quick to deny the Bankia run, with Fernando Jiménez Latorre, secretary of state for the economy stating, “It is not true that there has been an exit of deposits at this time from Bankia… there is no concern about a possible flight of deposits, as there is no reason for it.”¹⁰ Funny then that the Spanish government had to promptly launch a €9 billion bailout for Bankia the following Wednesday, May 24th, an amount which has since increased to a total of €19 billion to fund the ailing bank.¹¹ Deny, deny some more… panic, inject capital – this is the typical government approach to bank runs, but the bailouts are happening faster now, and the numbers are getting larger.

The recent bank runs in Greece and Spain are part of a broader trend that has been building for months now. Foreign depositors in the peripheral EU countries are understandably nervous and have been steadily lowering their exposure to Eurozone sovereign debt. According to JPMorgan analysts, approximately €200 billion of Italian government bonds and €80 billion of Spanish bonds have been sold by foreign investors over the past nine months, representing more than 10% of each market.¹² The same can be said for foreign deposits in those countries. Citi’s credit strategist Matt King recently reported that, “in Greece, Ireland, and Portugal, foreign deposits have fallen by an average of 52%, and foreign government bond holdings by an average of 33%, from their peaks.”¹³ Spain and Italy are not immune either, with Spain having suffered €100 billion in outflows since the middle of last year (certainly more now), and Italy having lost €230 billion, representing roughly 15% of its GDP.¹⁴

Tags: Bailout, Bank Of Greece, Banking Crisis, Banking System, Bloomberg, Business Deposits, Collapse, David Baker, Depositors, ECB, Emergency Fund, Eric Sprott, Escalation, Euro Stoxx, Greek Banks, Infusions, liquidity, Reuters, S 165, Sprott, Withdrawals
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Gold: The World’s Friend for 5,000 Years

Saturday, May 19th, 2012

Gold: The World’s Friend for 5,000 Years

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors

Facebook’s highly anticipated initial public offering today helped the company raise $16 billion, a record for tech IPOs. It’s refreshing to see investor excitement rally around the stock, as the U.S. needs innovative businesses to thrive and attract capital. However, as behavioral finance warns, be cautious of a herd mentality.

Last November, the IPO deal of the day was Groupon. On the first day of trading, shares rose to a high of $31 from an initial offering price of $20.

By Thanksgiving, the stock had fallen below the IPO price, and only a few months later, uncertainty popped up around the company’s accounting methods and financial controls. The stock fell further, with the market devaluing Groupon by about 50 percent in only six months. How’s that for a group buy?

It’s interesting to note that the value of Groupon’s stock has lost more than $13 billion since the peak on the first trading day through April 30. For comparison, if you look at the total net assets in Lipper’s precious metals mutual fund peer category, assets fell $8.3 billion over the same timeframe. Investors lost more than $5 billion more in one tech stock alone than in all of the precious metals funds combined.

Gold—A Reality Check
Investors have “defriended” gold recently in favor of the dollar, as Greek and French voters rejected austerity measures. Greeks have been responding to their escalating debt issues for a while by steadily pulling money from overnight deposits. I often say, money goes where it is best treated, and these deposits will need to find a safe haven.

It’s not only Greece the market is worried about, says BCA Research. In a special report aptly named, “In Case of Emergency Grexit,” the firm says there’s extra pressure on Spain and Italy, “which imminently needs a large bailout of its banking system.” The 10-year yields for each country have reached 6 percent today, and while there are funds to sufficiently cover Spain, there aren’t enough funds for Italy, too, says BCA.

So if the European Union (EU) stops the flow of bailout funds, Greece, unable to pay wages, would invoke social unrest, according to BCA.

More importantly, without funds from the EU, Greece would default on its bonds. Looking at what the country owes this year alone, $1 to $7.6 billion is due each month, says BCA. The European Central Bank would then most likely stop providing funds to Greek banks, causing more individuals to pull money. “With deposit flight, and no injections from the ECB, the banks would be bust and Greece would be hemorrhaging money,” says BCA.

It’s also important to look at the investors of Greek debt. According to the London Evening Standard earlier this year, French banks are the largest holders of Greek government bonds and private-sector debt in the eurozone, with $47.9 billion exposure to Greece.

In the end, I believe governments in Europe lack the courage to be fiscally disciplined. Earlier this week, I told Aaron Task and Henry Blodget on The Daily Ticker that when push comes to shove, Europe will likely continue to print money. This should be positive for gold.

At the Hard Assets Conference earlier this week, Greg Weldon compared the money printing situation to a sink. In an interview he gave with The Gold Report, Greg said:

“It’s going to be very difficult to see how economies in Europe, the U.S. and Japan can stand on their own two feet without the assistance of central banks debasing currency through debt monetization. I liken it to filling the sink halfway up with water and pulling the plug out of the drain. Of course, the water level will recede unless you turn the faucet on and start more water pouring into the sink. The level of water represents asset prices, the water flowing out of the faucet represents liquidity provided by global central banks and the drain represents the real macro economy, which has not been fixed.

“At the end of the second round of qualitative easing, when the Fed shut off the faucet, the water level (asset prices) started to go down. But now the water is running again—particularly with some of the measures instituted by the European Central Bank, with its three-year loan program, the federal liquidity swaps and the back-ended way that it’s managed to involve the International Monetary Fund.

“The problem with all of this is it does nothing to fix the underlying problem, which is too much debt. This is not sustainable. Central banks turning on the water faucet is good for asset prices. The real solutions of fiscal austerity, which are probably not palatable to most politicians in Europe, are the real struggle as we go forward. This problem is not going to go away.”

So, during times like we’ve had recently, when the dollar is chosen over gold, I apply math. The chart below shows the 60-day percentage change of the gold price and the U.S. dollar. Gold’s recent weakness has triggered a -2.2 sigma event in standard deviation terms. Over the past 10 years, this has happened less than 2 percent of the time. Historically, each time gold has touched the -2 sigma mark, the precious metal has rallied.

This bounce is exactly what we saw on Thursday and Friday this week.

See more slides from my Hard Assets Investment Conference.

While gold may not go up vertically from here—as frequent readers know, the yellow metal historically has fallen in June and July—with the extraordinary events occurring in Europe, I believe investors will soon “friend” gold once more. As we wait for the central banks around the world to act, I encourage investors to consider dollar-cost averaging. It’s a way to stay invested, and more importantly, to avoid making emotional investment decisions.

Tags: Accounting Methods, Austerity Measures, Bailout, Behavioral Finance, Chief Investment Officer, Deal Of The Day, Debt Issues, Extra Pressure, Frank Holmes, French Voters, Herd Mentality, Initial Offering, Initial Public Offering, Investor Excitement, Ipo Price, Lipper, Net Assets, Offering Price, Precious Metals Funds, U S Global Investors
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From Idiosyncratic to Idiotsyncratic. Greece and HY ETF’s (Tchir)

Thursday, May 17th, 2012

by Peter Tchir, TF Market Advisors

The idiosyncratic risk is really coming from two sources and the fact that at the margin they collide is adding to the confusion and the volatility in the market.

Right now the problems in Europe are directly tied to Greece. Spain and Italy continue to have problems, and nothing is close to being resolved, but the real next catalyst in Europe is Greece. All this talk of a “Grexit” seems somewhere between premature and dangerous. I think Greece is likely to leave at some point, but several things have to happen before it can leave without causing a tidal wave of destruction across Europe and the global economies:

• Determine what will happen to the money owed to the ECB and the IMF. They too need to be redenominated at the very least, and possibly defaulted on in order for the new Greece to have a chance. What does that do for the reputations of those two institutions? How will the ECB make up for the loss? Will the IMF firewall remain intact after losses? Real issues that cannot be dismissed, and addressing some worst case, rather than best case reactions needs to be dealt with.
• Will Greece have the natural resources stockpiled to survive the immediate after effects? I see the risk of spiking energy costs as being one of the biggest risks. If the Drachma trades poorly against the Euro, and the Euro trades poorly against the dollar, how are people and businesses going to be able to afford items that need to be imported. For all the bizarre ways in which the bailout has been done so far, Greece has the luxury of not being forced into an immediate devaluation, so has time to prepare for some of the obvious risks.
• Portugal, Spain and Italy. I don’t see anything in place that would stop these countries from being immediately dragged down. Currency controls and a force redenomination in Greece will scare people in these countries. Capital flight at all levels will become a big issue. Trade in Europe could grind to a halt. How will contracts with Greek companies be dealt with. People will assume the worst in other countries and there is a real risk that trade dries up because even short term credit becomes completely unavailable. The ECB is likely to have to take unprecedented actions such as guaranteeing repo lines, and even settlement risk.
• The EFSF incubates contagion. Now maybe the EU will realize what many of us have being saying all along. The EFSF (and ESM) ensures that contagion will spread. If the EFSF is to be a source of money for anyone (notwithstanding its own losses on Greek loans), they will either be relying on Spanish and Italian guarantees, adding to the misery in those two countries, or, far worse, those countries will become “stepping out” members as well.
• Target2? Bank debt? Bank debt guaranteed by Greek central bank? So many other questions, so few of which have been addressed.

I don’t know what will happen if Greece leaves. I am not certain that we will see contagion quickly spread and Europe grind to a halt, but that scenario, given the current level of preparation, and the precarious situations in Spain and Italy, I find it impossible to believe politicians will ignore that risk in the end. The other issue here is that the entities that you would normally expect to see step in after a default, like the IMF, have already stepped in. The IMF, ECB, and EFSF, all of whom would be relied on to help after a big event, are already part of the big event. That is unusual and makes the situation far more difficult to contain.

The Greek drama will play out, but Grexit will not happen yet, and both sides will find enough ways to claim victory that some concessions will be made to give Europe and Greece more time to prepare. At this stage, that would be a big positive for the markets which right now are largely ignoring that most logical outcome.

You cannot mention idiotsyncratic risk without talking about JPM. Whatever the trade was, in all of its iterations, it is clear that it got so big relative to the liquidity in the market, that it was driving prices. Too tight at one point in hindsight, and possibly too wide right now, but that is yet to be determined. Every part of the fixed income world is being affected by the alleged unwind. It really doesn’t matter at this stage what position JPM has or doesn’t have. Whether they are unwinding or adding, whether they are being front run or not? The only thing that matters is that liquidity has dried up. No one wants to be the other side of a trade if they think it can be part of some alleged massive unwind. Liquidity, already limited with everything going on in Europe basically disappeared after the JPM announcement. The swings in CDS and now cash have been large. It takes very little trading to move the market. At certain prices, for whatever reason, big volumes go through, but the gap to the next “clearing” level seems random and large.

You cannot ignore these moves, but being dragged around by a battle that is occurring on a higher plane has its own risks. The markets will revert quickly and in ways that don’t let you get back in if you want. Not one to say “close your eyes” and ignore it, but to some extent you have to “close your eyes” and ignore it. It is impossible to separate out what is technical and specific to the JPM from the usual technicals. Games are being played and pictures are being painted on a scale that rarely occurs.

IG18 is trading at fair value. IG17 is actually trading cheap to intrinsic value. MAIN is trading cheap as well. This means that the indices are trading wider than their components. Since part of the allegations against the whale were that their trading drove indices to trade extremely tight to fair value, that has over corrected (it can over correct further, but that part of the problem is now out of the market). To me, this is a clear sign that the desire to put on “liquid” hedges has gotten more extreme and weak shorts are being created. Then looking at single name CDS versus the cash bond market, and it looks like CDS has underperformed here as well. So single name CDS, another “hedge” vehicle has done worse than the cash, and the index has done even worse. We have again a typical situation where rather than selling cash, some people have bought protection at prices wide relative to bonds. That often ends in a big gap where either bonds underperform or CDS outperforms. I’m leaning towards CDS going tighter, but cannot discount the potential for bonds to do worse.

Which brings us to HYG and JNK and their weak performance. There are two key drivers here and both are somewhat strange. The ETF’s are effectively a representation of the bond market and they tend to trade to either the “offer” side of the market in good times, or to the “bid” side of the market in bad times. What does that mean? It is relatively safe to say that the average high yield bond is quoted in 1 point markets. So if a bond was quoted as 98-99, in a strong market, the ETF tends to trade closer to the “99″ price as the offer getting “lifted” is the likely trade. As the cash market weakens, two things tend to happen. The one is obvious, the price drops, the other is that the bid/offer spread also widens. So this same bond that was quoted 98/99 will now be 97/98.5. In spite of the bid dropping faster than the offer, that is the more likely side to be executed on, so the ETF, reflecting market sentiment, will drift to the bid side, and now reflect a “97″ level. So the ETF could drop 2 points while the fair value, based on “mids” only dropped 0.75%. This move, while large, is as much a function of how high yield bonds trade as it is a reflection of real weakness. Remember the ETF’s are only a proxy for the underlying market, so this move from the offer to bid side explains a lot of the relative weakness of the ETF’s.

I’m seeing both HYG and JNK trade “cheap” to fair value. They are trading at a discount. That means the “reverse arb” comes into play, which can put added pressure on the ETF’s. It doesn’t surprise me, that JNK which generally is more lenient on the share redemption (and creation) process is experiencing more outflows than HYG, because the arbs will focus on it.

Be careful, but also don’t forget, that although we get lulled into a sense of liquidity in the ETF’s, at some level, the poor liquidity and wide bid offers in the underlying bond market come into play, and we are seeing that now.

I think the U.S. credit markets are attractive, I continue to like them, and am looking at adding more. I am not sure the time is right, but the price action in the U.S. is starting to become encouraging, and I’m seeing some signs that the whale feeding frenzy is over, which is encouraging. I would like to see some more evidence that Europe understands they aren’t ready to kick Greece out and that they will lose more than Greece, but for the first time, I’m seeing much more balanced comments and not everyone is on the Grexit bandwagon.

Tags: Bailout, Capital Flight, Catalyst, Currency Controls, Devaluation, ECB, Energy Costs, ETF, Global Economies, Hy, Idiosyncratic Risk, Imf, Natural Resources, Portugal Spain, Redenomination, Reputations, Tidal Wave, Volatility, Wave Of Destruction, Worst Case
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