Monday, November 21, 2011

Europeans are working feverishly on backup plans for when the whole Euro project unravels....

Europeans are working feverishly on backup plans for when the whole Euro project unravels....

by Doug Noland

Spain paid 6.975% at Thursday's 10-year debt auction, the highest funding cost since prior to the introduction of the euro. Italian 10-year yields traded above 7.1% yesterday, near the level the market associates with previous European Union bailouts for Greece, Portugal and Ireland. At the same time, the spread between French and German 10-year debt widened at one point to an alarming 200 basis points (bps).

Probably most troubling, two-year funding costs surged across the euro region. French two-year yields rose to 3.80% Thursday (after beginning November at 3.09%), almost 340 bps higher than comparable German yields. After beginning the week at 3.05% (and the month at 2.53%), Belgium two-year yields traded 95 bps higher in four sessions to 4.0%. Austrian two-year sovereign yields jumped 40 bps to trade yesterday as high as 1.82%.

Money is on the move, and one is left pondering how the markets would have functioned had the European Central Bank (ECB) not been there with substantial ongoing support.

Last week, even so-called "core" sovereign debt markets succumbed to marketplace illiquidity. Yet an even more desperate situation was unfolding in the banking system funding markets. UniCredit, the largest Italian bank with nearly a trillion euros (US$1.35 trillion) of assets, found itself in the spotlight. A Bloomberg article noted that the bank has $51 billion of bonds to refinance, while the market yield on the bank's bonds has surged above 10%. The head of UniCredit was said to have met with officials at the ECB, seeking additional funding for the troubled Italian banking sector.

In Friday's Financial Times (Tracy Alloway) - "European Bank Funding Slows to a Trickle" - it was noted that European banks have about US$660 billion of debt maturing next year. The article highlighted the rising cost of attracting both retail deposits and professional investors, while touching on the issue of capital flight. "And, as far as 'peripheral' eurozone countries are concerned, market participants are already on the look-out for a deposit flight - one of the more serious signs of bank funding nervousness - that would add to banks' problems."

The article noted that Greek deposits had fallen by a fifth since the start of 2010, while funding from the ECB had jumped to $120 billion. The market is now on watch for what would be a very problematic run on Italian and Spanish deposits.

With a crisis of confidence impairing the markets for both sovereign and banking finance, it was seemingly yet another "inflection point" week in the marketplace. Increasingly, the markets are viewing the situation as unsustainable. With Italian debt in a downward spiral, the soundness of the entire European banking system is in serious jeopardy.

Troublingly, there was heightened focus on counterparty and derivative issues, including US bank exposure to European debt, the sovereign credit default swap marketplace and other counterparty exposures. Fear that EU governments will be forced to recapitalize their faltering banking systems has weighed heavily on already depleted confidence in the creditworthiness of sovereign credit. Increasingly, the credit standing of France, residing near the epicenter of Europe's "core", is imperiled by the possibility of a massive bank recapitalization program.

So, the powerful force of contagion effects has the marketplace convinced that something has to give. The EU is running out of options, as market confidence deteriorates by the week. European monetary union is at heightened risk. This has set in motion "capital flight" dynamics that risk strangling individual banks and banking systems, especially in Spain and Italy.

The ECB has stepped up support for Spanish and Italian sovereign debt. The market takes little comfort in these operations, appreciating that this is seemingly the only bid in an essentially frozen marketplace. As the situation turns dire, market participants assume that the Germans and ECB will have no option other than to back down and assume the role of "buyer and guarantor of last resort".

Markets were buoyed on Friday morning by the Dow Jones headline, "ECB Lending to IMF Proposal Gains Traction". Reader enthusiasm was doused with rather chilly water in just the second paragraph: "Germany and the ECB are still opposed to the idea but with no other viable alternatives talks could start soon. 'There is urgency in this as something must be in place if Italy needs a bailout,' a senior euro-zone government official said." There was likely some comfort taken by market participants that have been waiting for the Germans to start to burn from the heat of political isolation.

There remains a viewpoint that the Germans are behind the scenes performing an ongoing cost vs benefit analysis when it comes to eurobonds, ECB "buyer of last resort" quantitative easing, and more open-ended German bailout participation. As the thinking goes, German policymakers will eventually arrive at the conclusion that the cost to bail out troubled euro borrowers is less than the huge and unknowable risks associated with euro disintegration.

There is even a line of reasoning that the Germans are already prepared to support unlimited ECB monetization to stabilize debt markets, and that public protest of such a policy course is chiefly for domestic political consumption.

I, for one, don't believe ECB president Jens Weidmann (or other German statesmen) is bluffing or posturing. I thought it might be useful to highlight from an insightful exchange from a November 13, 2011, Financial Times (Ralph Atkins and Martin Sandbu) interview. Mr Weidmann's comments are relevant to the unfolding European debt crisis as well as to central banking more generally.
Financial Times: "Can you explain why the ECB cannot be lender of last resort?"

Bundesbank president Jens Weidmann: "The eurosystem is a lender of last resort - for solvent but illiquid banks. It must not be a lender of last resort for sovereigns because this would violate Article 123 of the EU treaty [prohibiting monetary financing - or central bank funding of governments]. I cannot see how you can ensure the stability of a monetary union by violating its legal provisions. I think the prohibition of monetary financing is very important in ensuring the credibility and independence of the central bank, which allow us to deliver on our primary objective of price stability. This is a very fundamental issue. If we now overstep that mandate, we call into question our own independence."

FT: "The impression is that the Bundesbank will stick by principles until the whole house burns down ... "

JW: "Right now we're talking about the EU treaty and I don't see how you can build trust in a system that violates laws."

FT: "Are you a pragmatist?"

JW: "I am president of an institution which is bound by a legal framework. We should respect the division of labour in a democracy. This has nothing to do with pragmatism or dogmatism."

FT: "What if there is a conflict between Article 123 and the risk of a refinancing crisis for Italian debt?

JW: "That assumes that you can address the issues in Italy with liquidity and that's not the case. This whole debate completely blurs responsibilities. Furthermore, monetary financing will set the wrong incentives, neglect the root causes of the problem, violate the legal foundations on which we work, and destroy the cedibility and trust in institutions. You won't solve the crisis by reducing incentives for the Italian government to act. It's really an absurd debate in which we are telling institutions: don't care about the law."

FT: "Why shouldn't Germany, which has total credibility in financial markets, loosen its fiscal stance?"

JW: "Germany has that credibility because it followed a specific fiscal path in the past, and it should not lose that track record and credibility by abandoning that path. It's very important that Germany remains the stability anchor within the monetary union."
And on Friday, from a speech given by Mr Weidmann in Frankfurt: "The lack of success in containing the crisis does not justify overstretching the mandate of the central bank and making it responsible for solving the crisis. The economic costs of any form of monetary financing of public debts and deficits outweigh its benefits so clearly that it will not help to stabilize the current situation in any sustainable way."

It would not appear that the Bundesbank is about to succumb to intense political and market pressures - and promote the ECB into the role as open-ended "buyer of last resort". For the Germans, it is a fundamental issue of core principles. The costs of "monetary financing" - or monetization - outweigh the benefits "so clearly".

Especially in the United States, there is a complete lack of appreciation for the myriad costs involved in central bank market interventions. For too long, policymakers and pundits alike have tried to paint "inflation" as the only real cost of "loose money" (ie low rates, market interventions and ballooning Fed holdings), a price too easily dismissed in a crisis environment. Yet Mr. Weidmann focuses not on inflation but on "credibility", "independence", "incentives", "trust", the rule of law and the critical importance of a "stability anchor".

It is my view that the control by contemporary central banking over inflation is overplayed, especially when contrasted to a central bank's profound role in nurturing a monetary backdrop conducive to a level playing field in markets and economies, to fostering a sound financial and economic backdrop, and to ensuring systemic stability.

Truth be told, "Monetary financing will set the wrong incentives, neglect the root causes of the problem, violate the legal foundations on which we work, and destroy the credibility and trust in institutions. You won't solve the crisis by reducing incentives ... "

This applies to the eurozone and it certainly applies to the US. I was struck by a comment Warren Buffett made earlier in the week on CNBC. Mr Buffett noted that "the US had the ability to do what was necessary" back in 2008, and Europe must find the will to do the same today. Many continue to miss the critical distinction between 2008's "private sector" debt crisis and today's "sovereign" debt crisis.

After years (decades?) of accommodation, markets are now much belatedly disciplining governments throughout Europe - and it's proving an incredibly more challenging dynamic than 2008. That markets are not today disciplining Washington is no cause for overconfidence or hubris.

Part of my thesis has been that the more the Germans saw of the European and, increasingly, global financial crisis the more determined they would be to safeguard their institutions, economy and credibility. The markets, of course, want the ECB to be more like the Fed, while I suspect the Bundesbank stares across the Atlantic and sees disaster in the making.

To anyone willing to see, the US central bank's credibility has been badly damaged, market incentives have been terribly damaged, and trust in institutions and the markets has been severely damaged. When it comes to rules and legalities, the Federal Reserve is making things up on the fly, with monetary policy becoming an anchor of instability.

All the same, as the markets see it, the US is fine for now but something really has to give in Europe. Systemic stress again last week reached the point where the markets began anticipating yet another dramatic policy prescription. The ECB, or the International Monetary Fund, or the ECB financing the IMF perhaps financing the European Financial Stability Facility that could finance Italy that could finance their banks that could finance the rapidly faltering European economy? What a mess.

It is the conventional view that European policy incompetence and lack of leadership have created a situation where policymaking simply cannot keep pace with a rapidly escalating crisis. Most believe this crisis didn't have to happen and that it can still be resolved with sufficient policy resolve.

I tend to look at the situation much differently. After disregarding the issue of monetary instability, associated price distortions, and credit and speculative excess for many years - and kicking the can down the road for too long - policymakers have hit the proverbial wall. They have suddenly lost the wherewithal to connect foot to can.

It's not that sovereign yields are unreasonably high, only that they've surged to not unreasonable levels so abruptly. A long-distorted market pricing structure has unraveled rather dramatically, leaving dangerously leveraged financial institutions and over-indebted governments (along with a bloated credit structure) in a dire predicament. It's not so much that recent policies have caused the crisis as much as it is a case where an incredibly challenging political and policy backdrop created an opening for the day of reckoning to burst right on through.

I'll assume that European (and global) policymakers are prepared to approach this crisis with only greater resolve. Markets are counting on it. But it also makes sense to me that the Europeans must now be working diligently behind the scenes on backup plans in case the whole thing continues to unravel.

Quietly, do they focus on saving the sovereign "periphery", the banks, or a group of "core" nations that might be able to salvage monetary union? It is increasingly apparent that resources are insufficient to sustain everyone. I'll presume the sophisticated "money" is maneuvering for the exits. There were times last week when I had a really bad feeling about how things were unfolding....

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