Month: January 2012

European Debt Crisis from Acute to Chronic, U.S. Markets Not Panicked

The European debt crisis continues to show signs of being transformed, like various (other) cancers, from an acute to chronic stage of existence. Our financial markets in the US no longer seem to panic at every new electrocardiogram reading on Greece, Spain, Italy, Portugal, Hungary – or even France.

As this site correctly predicted just recently, the European Central Bank’s hook-slide around German orthodoxy by flooding the European banking system with enough cheap Euros (QE on the QT) has had the desired effect not only of reducing the serious risk of a bank funding crisis but also of underwriting the ability of those banks to support their countries’ sovereign debt refundings – and at a profit, no less!

As a result, the alarming rise in Italian and Spanish and French sovereign debt interest rates has been arrested. Therefore, the threatening risk to the future stability of those countries’ budgets is now in remission.

US Economy Moves from ICU to Outpatient Care

Likewise, the US Federal Reserve has, again as we predicted, underwritten another two years of reliably low interest rates for US investors and business executives.

Chairman Bernanke, the Republican’s favorite punching bag next to President Obama, seems to recognize that the US economy’s problem has now shifted from the Intensive Care Unit to Outpatient care, while not yet being “out of the woods”. The Republican’s seem to think (wrongly) that they need to keep up the sense of an apocalyptic economic collapse to make their case. (Could it be that Central Bankers really do know what they are doing, despite what virtually all the Tea Party talking heads on CNBC say day-in day-out?).

Friday’s weaker than expected 4th quarter 2011 GDP estimate on the surface seems to buttress the Fed’s case, and surely 2.8% growth is a weak turn of recovery by most historical standards.

As this blog has observed in the past, most initial estimates of GDP are wrong, by large percentage factors, because the early report includes actual data (as opposed to financial model projections) only for the first half of the quarter. In particular, 4th quarter GDP tends to understate the trend, in either direction, i.e., if the initial data shows the quarter up, then more reliable data later will show it up even more, and the same for down trends.

While this is a small comfort to those who lost money on the stock market last week, perhaps they can bide their time and recoup their losses by buying back their shares before the corrected report comes out in late February!

One things for sure – the Fed will still be underwriting the economy this February…and next February…  and next February …

For Once, a Consequential Fed Meeting

Wednesday’s conclusion of the first Fed meeting of 2012 may herald a new working majority at the Board more closely aligned with Chairrman Ben Bernanke’s view of the economy and the role of the Fed in supporting employement as well as restraining inflation. What would be the consequences?

First, the identification  of an inflation rate of 2% , give or take a few basis points, as the specific target of Fed policy. Secondly, related to that objective, a new transparency with respect to the individual expectation of the Reserve  Board members as to the likely course of interest rates over the next several quarters and indeed as far out as 2014. This will not be revealed by name but by a sort of collective range of projections, dropping off the highs and the lows to try to contain market speculation as to who on the Board  specifically is the high or the low. Thirdly, related to these projections, would be a change in the language of the Fed’s starement heretofore guaranteeing low interest rates through mid-2013 — words will be added to in effect EXTEND the period of low rates into 2014. And finally, there may even be an initiation of a form of QE3 — the Fed’ s version of stimulus — this time focused squarely on the housing market by way of extending the Fed’s purchases of bonds from Treasuries to mortgage-backed securities.

All four of these actions may not be reflected in the official post-meeting statement ,and some may come out shortly after the meeting. But any one of these four actions would lead the financial markets to anticipate the other three in due course. The main concern, if and when the entire policy package comes together, is whether the markets will somehow misinterpret the Fed’s “new transparency” in ways which the Fed does not intend and would soon have to correct, especially in the face of continued market nervousness about the Euro debt crisis. (The US markets simply have yet to understand that all negotiations continue on to the next Euro “Summit” —  because no side can politically or financially afford to leave an impression that they gave in too soon – this is all that is really going on with the Greek debt issue.)

It’s Still A Greek Haircut — Short Back and Sides

Here’s what’s going on with the European Debt Crisis, and particularly the Greek bond “haircut” negotiations; the fact that the barbershop closed over the long three-day weekend is of much more moment than the Standard & Poor’s downgrade of most Eurozone sovereign credits, which was widely anticipated by the financial markets (we should have guessed they would do it on Friday the 13th).

Here’s the deal:

Greece owes more money to its bondholders than it can ever afford to pay off, so the Eurozone “leaders” came to an agreement with the representatives of the major bank holders of Greek bonds back in December that the holders  would take a 50% haircut on the face value of their holdings in an exchange of those securities for new Greek bonds of considerably longer duration; but they deferred setting the  exact terms of exchange, including importantly the interest rate they would be paid on the new longer term debt  That rate — if set too low – would of course constitute an even deeper ‘haircut’ on the total value of their  holdings.

Most of the banking institutions holding  Greek sovereign debt can ill afford write-down on their balance sheet beyond 50%, which would put them in potential need for financial bailouts from their governments (the same governments S & P just downgraded, in part because of this very risk. But of course these governments would also have to pony- up more money to Greece if the interest rate is set so high on the new bonds that Greece can’t afford to pay the it off when due! It is this “balance of terror” that negotiators in December  felt would  lead to a rational, face-saving (as well as other-parts -of -the-anatomy-saving) deal on the interest rate that all parties could live with, by now.

Most of these bank holders bought the debt early on, but only some have the protection of hedges with credit default swaps, which would  theoretically (depending on the solvency of the counter-party) pay 100% of face value if Greece forced a haircut by legislation and thereby actually “defaulted”. The existing bonds are governed by Greek  law, which Greece could at least try to change to force harsher terms on the holders. Thus  the banks are  being “asked”   to choose between getting 50% or less of face value by “voluntary’ agreement, or, in a some but not all cases, take their chances on getting 100% through their CDS “insurance” under circumstances where the whole financial system might nonetheless collapse (a la Lehman) around them — and their insurers — because a forced conversion would likely foreshadow  a disorderly Greek default, which is exactly what most everyone has been trying to avoid! look like a voluntary haircut deal to me.

But now come some  hedge funds (the only lower form on the financial system’s Tree of Life apparently lower than Bain & Company in a Newt Gingrich taxonomy) that bought up Greek sovereign debt a the current market rate of t20-25% of face value, looking to cash in on the 50% haircut deal that they thought  would be a 100% windfall for themselves. And they have the Gaul (some of them may be French) to be so upset by the low interest rate Greece proposes to pay on their new bonds (with a push from the IMF,  Greece’s lender of last resort, which loves its own pocket book more than the hedge funds’ for sure) that they are threatening to walk away from any “voluntary” deal — I guess because just a 75% profit in a couple months isn’t enough). Greece being aware of this has threatened to change Greek law on the hedgies to force them to go along with a haircut deal struck with a majority of holders (the banks stuck, as described above,  between a rock and a hard place), knowing that this amounts to a default that could bring down the whole Euro house —  including Greece, as their Finance Minister well knows. The hedge funds seem tempted to bet that, rather than see that event happen, even the new Iron Lady of Europe, Frau Merkel, will come up with the  dough to let Greece pay a high enough  interest rate on the new bonds to keep the hedgies in hedge heaven.

Do we see any public spirited citizens in the room? This is not the first time the hedge funds or the Greeks  have played chicken with the world economy. My guess is that sometime in the next week Merkel will politely but firmly tell them  to stop the games or go to hell (namely, back to the drachma). This posture  worked in December with a slightly different cast of characters, and it worked with Berlusconi. But we may have a return to the wilder market days of last fall for a few moments this coming week or two before the dust settles. The effects of S&P’s downgrades can wait on this, because the too-easy ‘solution’ of letting Greece default is too much like the pre-Lehman “moral hazard’ talk that caused us all the trouble in the first place.Because if Greece is the new Lehman, then Italy, or Spain, or even France, is the next AIG, Merrill Lynch, or Bank of America, with or without further downgrades. But definitely without the lender of last resort that the Fed and the US Congress were able to be…unless the Iron Lady takes off the leash she holds on the ECB — dream on hedgies!

 

Questions for the Markets

1. Euro and Euro sovereing debt prices go down, the Us market goes down (even with strongly improved US employment, manufacturing and consumer spending). Are hedge funds that are short the US stock market and anxious to get back long at lower levels effectively shorting Italian and Spanish sovereign debt with derivatives in order to drive down the US markets?  (Yes.)

2. Did the stock market get traded down by the big funds on this friday get traded down despite the good employment numbers because those numbers tend to help Obama, whom the  hedgies hate? (yes again.)

3. Are the Euro currency and bond vigilantes driving down sovereign  bond prices this week to force “Markozy”to give in to market pressures at their meeting next week and turn loose the ECB to directly support bond prices? (Not a chance.)

4. Will the ECB lower interest rates next week? (My guess yes, but the market thinks no because of the falling Euro. But  note that Germany must really, secretly like the falling Euro, at least for a while — helps their exports outside Europe.)

5. Is Standard and Poor’s holding off downgrading France because it has become afraid they will be blamed for killing Sarkozy’s re-election and ushering in a Socialist government in France in this April’s election?

6. Will the US Fed announce QE III in the mortgage bond markets sometime shortly after its January meeting? (Y

7. How many governors (and current opponents) has Romney promised  to be on “really  short list” he VP nomination to? (at least six.)