Summary
- EU Debt Crisis Scheduled, Potential Events, Ramifications
- EU Finance Ministers Meetings May 17th-18th: Sovereignty Or The Euro?
- Needed EU Control Over National Budgets = End of National Sovereignty
- Indicators of PIIGS Bond Sentiment
- Major EU Stock Exchanges and Financial Stocks
- ECB Bond Sterilization Plans
- Ramifications Of EU Actions This Week
- Growing Deflation Story EU, China, US, Japan And Ramifications
- US Banking Investigations
Longer Term Technical Perspective
EU Debt Crisis Scheduled, Potential Events, Ramifications
Here’s a quick recap of the past 10 days.
May 6th-7th, global asset markets collapse on growing fears of Greek and other PIIGS block bond defaults, which also stops interbank overnight lending, threatening a European banking collapse that would likely spread worldwide.
Sunday May 9th: The EU/IMF reverses its former disciplined hard currency approach to the biggest bailout ever, complete with readiness to purchase bonds of any member nation facing default.
Monday May 10th: Global markets rally on the deferred default threat
May 11th-14th: This rally stalls out on doubts that the new plan can be implemented and enforced. Doubters included the CEO of Deutsche Bank Josef Ackermann (May 13th: Greek default/restructure likely) and former Fed Chairman Paul Volker (May 14th: Euro on the brink of disintegration). May 14th reports that French PM Sarkozy had to threaten Germany with French withdrawal from the EU in order to get the much smaller € 100 bln March 25th plan added to fears of EU instability. As noted below, the fact that Southern European bonds comprise about 22% of French bank assets may have had a role in inspiring Sarkozy.
Thus events surrounding the unfolding EU Debt Crisis remain the top market movers for the coming weeks. Top ones to watch include the following.
EU Finance Ministers Meetings May 17th-18th: Sovereignty Or The Euro?
Look for attempts to calm markets and restore the EU’s tattered credibility. How?
The EU’s crisis is primarily due to its unworkable combination of a unified currency with independent national spending. That has permitted the unaffordable spending of Greece and the other PIIGS to threaten the EU’s existence. That brings us to the big choice the gathering needs to make – the Euro or continued full national sovereignty.
Needed EU Control Over National Budgets = End of National Sovereignty
The European Commission has already published recommendations that essentially subject national budgets to EU approval to prevent a repeat of the current problem of member state mismanagement threatening all. Germany has not objected, despite Merkel’s previous policy that the Bundestag, not the EC, set German budgets.
As numerous commentators have noted, the ability to tax and spend is the essence of national independence.
Watch for news on this topic from the meeting. Without movement towards EU supervision over national budgets, the EU won’t rebuild confidence that it can avoid a similar crisis.
However, are the individual states ready to choose the Euro over their independence?
Indicators of PIIGS Bond Sentiment
Like its predecessors, the real goal of the latest EU/IMF aid plan is to calm markets enough so that PIIGS bond rates fall enough so that they don’t need any aid and can borrow on the open bond market. The test of this will be how coming PIIGS bond sales fare.
-PIIGS Bond Sales: Encouraging Thus Far, More This Week
Results thus far have been encouraging.
Last week Portugal was able to sell€1bn of 10-year bonds with a bid to cover ratio of 1.8 and an average yield of 4.523 per cent. This was only 18 basis points more than the yield on its previous 10-year auction in April, which was encouraging given the near meltdown in the market last week.
Italy sold €3bn of 5 year notes at an average yield of 2.57 per cent, 2 basis points lower than existing comparable debt, indicating strong demand. Benchmark Italian bond yields, which have an inverse relationship with prices, fell 8bp to 3.84 per cent.
The ECB has so far bought €20bn in euro zone government bonds as part of the support package, according to dealers.
This Tuesday May 18th: Ireland will sell 4 and 10 year bonds of a total around €1.5 bln. Markets have thus far shown faith in Ireland’s commitment to fiscal reform
This Thursday May 20th: More important will be Spain’s planned 10 year bond sale of around € 3bln to test market sentiment on Spain’s latest spending cuts. Last week Spain announced new deficit reductions by an additional 0.5% of GDP for 2010 and 1% of GDP for 2011. These included cuts to civil servants pay, and may not be legal under Spanish law.
Late last week PIMCO’s CEO warned that the ECB’s purchase of PIIGS bonds on the secondary market may be backfiring because it provides a chance to sell these bonds for those that would otherwise have held them and thus supported their value.
Major EU Stock Exchanges and Financial Stocks
- Watch the French CAC. Per IMF estimates, Southern Europe bonds comprise about 22% of all French bank assets. Anxiety about PIIGS bonds will show up fast here.
- Watch banking stocks (Santander -6%, Soc Gen (SCGLY.PK) Credit Agricole (CRARY.PK) among others that took big hits last week because of their vast exposure to PIIGS bonds. are taking a hit as the various European central banks have ceased buying PIIGS government bonds in the secondary market.
- Per Morgan Stanley (via businessinsider.com), a number of major EU insurance companies have significant PIIGS exposure. Watch their stock prices as another measure of confidence or anxiety about the PIIGS default risk.
Insurance: Potential contagion risks for giants
13 May 16
ECB Bond Sterilization Plans
In the coming days the ECB is expected to announce details of how it will prevent its bond purchases from stoking inflation. The ECB’s Stark has hinted the ECB may hold the debt until it matures.
Ramifications Of EU Actions This Week.
If the EU succeeds in calming markets, risk assets stabilize or recover. In particular, the EUR/USD holds support around 1.2400. If not, more downside near term to 1.1600.
Growing Deflation Story EU, China, US, Japan And Ramifications
As numerous market analysts have been warning over the past months, including Charles Nenner (Nenner Research Center) and David Rosenberg (Gluskin-Sheff), deflation and shrinking GDPs are more of a concern than inflation.
The plunge in oil prices is a clear sign of fear that investors are de-risking ahead of a possible slowdown and protracted deflation: Oil is now below $72. Less than 2 weeks ago it was near $90.
EU
Watch CPI and PPI data. Deflation and its drag on GDP threatens to bring a continued Euro decline if not outright EU dissolution.
Spain’s underlying inflation rate just turned negative in April for the first time in at least 25 years and this is likely just the beginning, as we have yet to see the full brunt of fiscal austerity hit aggregate demand. Core consumer prices, which exclude energy and food, dropped 0.1% from a year earlier.
Given that none of the EZ nations come close to meeting the Maastricht budgetary targets, all could be facing severe deflation pressure in the future based on the amount of slack in their economies and need to cut spending.
As reported by businessinsider.com’s Joe Weisenthal here Rosenberg notes:
Ireland is already experiencing deflation, with nominal GDP falling faster than real GDP (both are down for two years straight but nominal is falling faster — nominal GDP was down by 11% in 2009, real down 7.5%). Not surprisingly, there is a lot of slack in the economy and the output gap stands at -7.1%, which suggests more deflationary pressures over the medium term. This problem is now widespread: Spain has an output gap of -5.3%, Portugal -3.6%, Italy -5.7% and Greece -4.6%.
This Threatens The EZ ‘s Existence And/Or The Value of the Euro
Weisenthal correctly notes what this ultimately means: A choice between Euro devaluation or EZ shrinkage (if not outright dissolution):
Even with the recently announced austerity measures for Spain and Portugal, these countries may have trouble improving their fiscal ratios, if deflation sets in and GDP falls (as it has in Ireland). It’s otherwise known as the ‘catch 22’ — and the future of the Euro zone project, as it currently stands, is more in doubt than many are willing to believe at the current time. Either the Euro plunges or several of the EMU members will inevitably opt for their own currency of yesteryear to ease the deflationary pressure on their economies.
China
China – China’s stock markets have for some time been a leading indicator for US markets and risk assets in general. The Shanghai Index is down 20% from the highs of the year.
As the most prominent economic growth engine given its combined size growth rate, recent measures by China’s central bank to tighten liquidity is a challenge for a world drowning in debt and slow growth or contracting GDPs from austerity measures.. The recent increase in consumer prices of 2.8% in China exacerbates the problem as it encourages further tightening.
As we’ve noted over the past weeks, a variety of prominent fund managers and researchers including James Chanos, Marc Faber, and Charles Nenner have all claimed that China is facing a bursting construction and real estate bubble which will bring declining prices to this sector similar to that seen in much of the West.
US
Dollar Strength, EU and China Slowdown Bring Deflationary Pressure to US
A slowing EU and China, as well as an appreciating USD would hurt US growth by themselves. However the US is already feeling deflationary pressures. Per Rosenberg as reported by Joe Weisenthal here:
“The U.S. implicit GDP price deflator receded to its slowest rate in 60 years in Q1 (+0.4% from +2% a year ago) in a sign that this profits recovery is still being underpinned by cost cuts, tax relief and accounting shifts than by anything exciting on the pricing front.”
“The latest Case-Shiller house price index confirmed that we are into a renewed leg down in home prices…” which adds to the deflationary brew.
Japan
The Bank of Japan is actively continuing stimulus and has long openly expressed its prime concern is fighting deflation.
US Banking Investigations
US Bank Investigations: In addition to Federal probes and coming regulations, new troubles for critical US banking sector. This week New York Attorney General Andrew Cuomo ‘s investigation of eight banks has gathered momentum. Goldman Sachs (GS), Morgan Stanley (MS), Deutsche Bank (DB), Credit Suisse (CS), Citigroup (C), UBS (UBS), Credit Agricole and Merrill Lynch/Bank of America (BAC) are subject of a preliminary investigation into whether they misrepresented the risk involved in ABS/CDO transactions backed by subprime mortgages, bet against bonds they sold and if the practice was disclosed properly to buyers and misled the rating agencies in the run-up of the financial crisis.
So far no charges, and the likelihood of the banks being actually sentenced to make huge compensation payments is small unless additional evidence comes to light or Cuomo can prove that banks deliberately deceived ratings agencies like Moody’s & Co.
Government scrutiny of the financial sector is intensifying and will only get worse as senators fight for re election this November. Goldman Sachs (GS) is the most prominent of the group and if they drop the financials as a whole will likely follow. In the last few weeks GS’s credit curve has inverted. Credit protection on GS cost more for 1 year than 5 years. If this trend persists a debt downgrade for GS could be in the offing which would in turn send financial shares tumbling.
This past week the Senate Finance Committee decided to create a new ratings agency. The congressionally approved ratings body will likely remove the conflict of interest inherent in the current private rating agencies business model. Expect to see Moody/Fitch/S&P make a preemptive downgrade of various banks like GS to satisfy Washington.
Remember that the financial sector typically been a leading indicator for overall market direction. If GS drags the group down the rest of the market will suffer.
Longer Term Technical Perspective
In addition to those shown above, none of which are going away soon:
- Forex: As noted above, the longer fundamentals for the Euro remain to the down side, though it could take a near term bounce, especially if PIIGS bond sales go well this week
- Other Risk Assets: Watch the S&P 500 and Shanghai stock Index. As noted in our recent post A Simple Low Risk Plan To Short the S&P 500, we see more downside risk in the weeks ahead, meaning stocks, commodities, and risk currencies are more likely to see more downside. If things go sour in the EU, a lot more.
Scheduled Events
See the Abridged version of this post.
Disclosure: No Positions
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