Monday, August 15, 2011

Your move, Jean-Claude

Last week's FOMC statement read [emphasis added]:
To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent.  The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
Note that they didn't exactly say that they would keep rates low until 2013, they just said that they "currently anticipate" that they would keep rates low until 2013, which means that they can change their minds at any time - but never mind that.

Moreover, they hinted at another round of quantitative easing:
The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.
As with last year, there could be another round of fireworks coming out of the Jackson Hole meetings this year when Bernanke is scheduled to speak on August 26.

Stresses are showing up in the financial system
I don't believe that the market volatility last week was the result of the credit downgrade of US debt. Instead, it represents signs of stress showing up in the financial system.

Where is the stress coming from?

I have been writing about the relative performance of the KBW Bank Index (BKX) relative to the market since May (see my original post here). Since then, the BKX has violated a major relative support level. Past violations have been signs of major systemic risk in the financial system coming to light. The first instance was the Russia Crisis in 1998 and the second was 2007 with the Subprime Crisis. Now it's happening all over again when relative support was broken in June. The recent selloff in the markets only intensified the underperformance and the sector remains in a major relative downtrend.

Interestingly, the performance of the Regional Banks have been much better. The KRX Regional Bank Index did not violate relative support until last week:

What to make of the difference between the BKX, which includes all of the big too-big-to-fail (TBTF) banks, and the KRX, which are regionals more focused on plain vanilla banking? The difference is global and investment banking exposure. The TBTF banks have it and the regionals don't, or have a lot less.

The logical conclusion is that the difference in performance in BKX and KRX performance are concerns over a European banking crisis, which the Fed will only play a secondary role in. True, the recent relative breakdown in the KRX is worrisome and likely reflects concerns over a the effects of a slowdown on an already fragile US economy (e.g., see this recent story indicating that 64% of Americans can't handle a $1,000 emergency expense), but it could be a false signal because of the incredible market volatility last week.

The biggest macro problem remains Europe.

Consider what Ambrose Evans-Prichard wrote in the Telegraph under the headline Eurogeddon postponed again as ECB gains three weeks about the ECB announcement that it would buy Club Med debt in the open market:
Unless the ECB is willing to back up its new role as lender-of-last-resort with massive purchases of Italian and Spanish debt, it will inevitably be tested by markets. Weak hands will take advantage of rallies to offload holdings onto the ECB, i.e. onto eurozone taxpayers. Frankfurt will find itself underwater very quickly without a legal mandate or EU treaty authority.
The problem is the unfunded EFSF [emphasis added]:
RBS calculates that the ECB will have to buy roughly half the outstanding tradeable debt of the two countries to defend the line. RBS calculates €850bn. I would put it nearer €1 trillion.
This is currently impossible. The ECB is acting as a temporary back-stop until the revamped EFSF bail-out fund is ratified by all parliaments over coming months. The EFSF will then take the baton.

Yet as we all know, the EFSF has no money. The parliaments have not even ratified the earlier boost to €440bn. As of today, the fund has barely €80bn left after all the commitments to Greece, Ireland, and Portugal. It remains a fiction.
...and the EU (read: the Germans) are adamantly against forking more euros over to save the Club Med countries. Both the FT and the WSJ are indicating widespread discontent with Angela Merkel over the prospect of more bailouts. Though there was a report over the weekend that the German government no longer rules out euro bonds, it doesn't actually say that they would actually take that step, but consider the option. Moreover, any government that pursues such a policy in the face of widespread popular discontent risks its own tenure in power.

Will the ECB throw in the towel and "do QE"?
What about the ECB as a white knight?

Joseph Cotterill of FT Alphaville recently wrote about the ECB in action in their "rescue" efforts. For newbies, let me explain how the mechanism works. Supposing that the ECB were to buy Spanish or Italian debt. Where does the money come from? One option would be for the ECB to print it (because central banks can print money out of thin air), which is variously described as debt monetization or (horrors!) quantitative easing. If it doesn't want to engage in QE, then it has to issue debt into the market and that activity is termed "sterilization", or "sterilisation", as the Brits would have it.

Cotterill outlined the dual problem of moral hazard and sterlization facing the ECB [emphasis added]:
Key points:
  • Italian government bonds outstanding: €1,597bn
  • Spanish government bonds outstanding: €576bn
  • ECB bond purchases outstanding: €74bn
  • Daily turnover on Italy’s electronic bond market (MOT) in June: €13.5bn
  • Typical size of a single ECB purchase: €25-100m
  • Italy/Spain holders looking to get out at a good price: many
Eventually the ECB also supported Greece, Portugal and Ireland ‘on a massive scale’, holding up to 20 per cent of their respective total debt stocks. If the ECB went on to hold that much of Italy, it would hold about €320bn (Spain €115bn).

So we have a problem. Actually, two problems. Whether the ECB can sterilise Spanish and Italian bond-buying if they get to a large size, and whether that size will itself become the big liquidity threat to Italian or Spanish bond markets over time as supply is sucked out. Hanging over all of it is the Securities Markets Programme’s long-running tendency to give long investors who want to sell an exit route at a good price, rather than encouraging them to maintain exposure.
Paul Kedrosky pointed out the differences between the Fed and the ECB in graphical terms. Just look at their balance sheets shown below. While the Fed's balance sheet has exploded upwards due to their QE2 program, the ECB balance sheet has been flat:

The mechanism for a rescue in Europe has been the Troika, consisting of the EU, the ECB and the IMF. The IMF is unlikely to take the lead in any crisis unless it's called upon. What's left is the EU and the ECB. Given resistance of the German public to further bailouts, the most likely candidate is the ECB.

Will the ECB finally "do QE"? Over to you, Jean-Claude!

Given risks of a banking crisis in Europe, anything that Bernanke announces at Jackson Hole is likely to be a sideshow.

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