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Posts Tagged ‘euro zone’

Citi’s FX guru Steven Englander is out with a note titled: What can go wrong in the next 11 days?

What’s 11 days all about? That gets us to May 3, the date of the next ECB meeting.

Given the heightened concern over Spain and Italy these days, this meeting takes on special importance.

A major risk is the risk of non-action:

The ECB doesn’t announce any measures for Spain and Italy

The next ECB meeting (May 3) is critical for both euro optimists and pessimists.  German yields are at record lows, euro zone bank stocks are at almost-record lows and  sovereign spreads are widening (Figure 2).  European policymakers very likely thought they had a break from crises after the Greek debt package and PSI were rammed through.  The rapid advent of the Spanish crisis, its spread to Italy, new concerns on the Netherlands and  very poor economic data have caught them flat-footed and so far there is no indication that any policy response is thought to be needed.

Before then, of course, we get our Fed meeting that wraps up Wednesday, to which Englander identifies risk of a hawkish tilt:

Now consider the risks that accompany Wednesday’s FOMC. Our economists write: “Fed officials are expected to reaffirm the need for a highly accommodative monetary policy ‘at least through late 2014.’ The Committee has set hurdles for additional QE-type asset purchases and at this meeting is not likely to resolve plans beyond the scheduled completion of Operation Twist.”  If the unexpectedly they shift the timing of the expected Fed hike to earlier in 2014, or even if “at least through late-2014” becomes “through late 2014”, we are likely to see pressure on bond markets, FX risk and very probably all risk correlated assets, — to a limited degree if “at least” is dropped, and much more strongly if the timing is changed. Very likely they will reiterate the previous timing, as our economists expect. Even for those of us who still think there is a significant chance of additional stimulus, the chance of misunderstood language at this meeting seems very high, when it is very unlikely that additional measures will be announced.

What may be a bigger risk is that some Fed governors and regional Fed presidents shift their expectation of tightening to earlier. When the last FOMC projections were published in January, three FOMC participants saw a need to tighten in 2012 and six in 2013. Six participants saw no need to tighten until 2015 or beyond.  If there is a shift in this distribution to earlier and tighter, investors may interpret the drift in the projections’ center of gravity as an early Fed-warning signal. Given the pricing in the fixed income market, this could easily be viewed as an stealth indication of tightening risk.

Of course, we’ll be covering it all, LIVE!

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A note to readers.  This 2000-word commentary is a longer-term view; think in terms of years, not months or days.  The essay is not in conflict with the fully invested position currently held at Cumberland. The words reflect my personal thinking only. Some of my colleagues disagree. In my personal view, the future is uncertain (of course) and may be unattractive for the longer-term outlook. In my view, our American political system is failing us.  In my view, we are joining the list of declining world powers.  The framework to support that argument follows.

“The external menace ‘You’ll end up like Greece, if you do not do this and that’ and the internal opprobrium heaped on some categories of taxpayers are very powerful and dangerous instruments to deprive people of their own personal freedoms.”  – Vincenzo Sciarretta

My friend Vincenzo is a journalist from Italy.  He is a serious writer and researcher.  He has covered the financial markets and economy of Italy for years.  He and I co-authored a book on Europe during the optimistic period.  If he and I were to write such a book now, it would probably be quite pessimistic.  

Vince responded to my recent email series about the downward spiral underway in the euro zone. Readers may find those essays at www.cumber.com. Vince noted my reports from the meetings in Paris and my reference to the upcoming French elections, where the promise of the Socialist candidate is to raise the tax rate on the highest income level to 75%. I will end this commentary with a longer email from Vince, in which he quotes historian Will Durant and discusses the fall of the Roman Empire.

Now to write some thoughts that gnaw at me in the late of the night, when sleep is elusive.  

Simply put: I’m worried.

When I get worried, I read and re-read in my library.  I can honestly say that I have had my nose in a thousand of those books.  The library holds many texts by giants.  They wrote about history, economics, and finance.  They took the strategic view.  George Akerlof, Jared Diamond, Niall Ferguson, Carmen Reinhart & Ken Rogoff, Robert Shiller, and Nassim Taleb are among the modern writers.  Milton Friedman, Martin Gilbert, Friedrich Hayek and his polar opposite John Maynard Keynes, Ludwig von Mises, R.R. Palmer, and Adam Smith are among the classics.

A favorite of mine is Paul Kennedy.  Twenty-five years ago, this Yale historian concluded his monumental work The Rise and Fall of Great Powers with a profound observation:

“In the largest sense of all, therefore, the only answer to the question increasingly debated by the public of whether the United States can preserve its existing position is ‘no – for it simply has not been given to any one society to remain permanently ahead of all the others, because that would imply a freezing of the differential pattern of growth rates, technological advance, and military developments which has existed since time immemorial.”

Kennedy then argued that the United States has the ability to moderate or accelerate the pace of decline.  Such is also the case for other great powers, many of which are in a state of decline from their centuries-old power peak. Among others in his treatise, Kennedy’s history lessons examine Spain, France, Rome, and the Austro-Hungarian Empire.

I think I just covered a lot of the euro-zone geography.  

In 1987, Kennedy warned us, ”The task facing American statesmen over the decades, therefore, is to recognize that broad trends are under way, and that there is a need to ‘manage’ affairs so that the relative erosion of the United States’ position takes place slowly and smoothly.”  He added the additional warning that it not be “accelerated by policies which bring merely short-term advantage but longer-term disadvantage.”

Unfortunately, America’s leadership has not heeded such warnings.

For decades futurists have complained about the rising use of government debt financing by the United States.  They predicted calamitous outcomes, which did not arrive as expected.  Paul Volcker and Alan Greenspan applied monetary policy in ways that allowed inflation and, hence, interest rates to spend a quarter century in decline. The Volcker-Greenspan era opened with the highest interest rates since the Civil War.  Building on this downward momentum, Ben Bernanke has taken the target short-term interest rate to near zero and held it there.  

During the same three decades, the US altered its fiscal policy, first under Ronald Reagan and almost continuously since. (The Clinton administration was the exception.)  Rising deficit financing has been facilitated by falling nominal interest rates.  That combination leads to level, or even falling, aggregate debt service.  You can owe more and more and have smaller and smaller monthly payments.  That is the magic of falling interest rates.  Until they hit the zero boundary.

What happens when the music stops and the chairs are full?  Are we reaching that point in the United States?  It appears we have done so in Europe, certainly in Greece, the eldest of the declining great powers.  We are also getting there in Japan and the UK.  All four confront similar financial straits: zero-bound interest rates coupled with expanding national government debt.  

About 85% of the capital markets of the world trade by means of the dollar, yen, pound, and euro.  The G-4 central banks have collectively expanded their holdings of government securities and loans from $3.5 trillion to $9 trillion in just four years.  At the prevailing very low interest rates, the functioning of monetary policy and the role of fiscal policy merge.  Is there any difference between a million-dollar suitcase of one hundred dollar bills and a million-dollar, zero-interest treasury bill?  You need an armed guard to protect the first one.  With the second one, you need to clear an electronic trade in a safe financial institution, not an unsupervised (no more Fed surveillance) Federal Reserve primary dealer like MF Global.  Your earnings on either the cash or the T-bill are the same: you earn zero.  You can use the treasury bill to secure a repo transaction at a near-zero interest rate.  You can use the cash to conduct many types of black-market or gray-market trades.  Is it any wonder that the hundred-dollar bill is so popular?  Isn’t it understandable that roughly two-thirds of US currency circulates outside the United States?

Is this a healthy situation?  How long can it persist?  What happens next?  When interest rates eventually rise, what will be the result of this blend of monetary/fiscal policy as its unwinding turns malignant?

Moreover, who then will be the politicians that inherit this mess?  Who will occupy the central banker’s chair?

I worry because there is no rationally explained strategic-exit plan in the G4. Not in the US.  Not in Japan.  Not in the euro zone.  Not in the United Kingdom.

I also worry because the direction of taxation is up, if certain politicians continue to have their way. I worry because US business tax rates are now the highest in the entire world.  In addition, I worry because of the increasing power that national governments wield in the mature economies of the world.  

Applied power eventually leads to serfdom.

Increasing taxation is a characteristic of a declining great power.  

 Governments are failing to heed Paul Kennedy’s warnings.  They are worsening the longer-term outlook.  The Western world’s leaders ignored Kennedy when he wrote “… accelerated by policies which bring merely short-term advantage but longer-term disadvantage.”

Zero-bound interest rates are a short-term advantage.  We enjoy them. We profit from them.  We expect them to continue for a while.  They are like the oxygen administered to a very ill patient.  If the patient dies, the oxygen has eased the pain in the terminal phase.  If the patient lives, the lungs have been scarred and need many years of healing and repair.  Today, the patient is receiving oxygen in the G4.  Death is being delayed (Greece) or, perhaps, thwarted (elsewhere in the euro zone, Japan, US, and UK).

We do not know how this will play out.  History only warns us that many of the likely outcomes may be unpleasant.   The authors I cited have articulated their differing and diverse views.  Their conclusions have tended to be in the form of warnings.

Paul Kennedy favors candor.  In his second, exquisite work, Preparing for the Twenty-First Century, he wrote: “Many earlier attempts to peer into the future concluded either in a tone of unrestrained optimism, or in gloomy forebodings, or (as in Toynbee’s case) in appeals for spiritual revival.  Perhaps this work should also finish on such a note.  Yet the fact remains that simply because we do not know the future, it is impossible to say with certainty whether global trends will lead to terrible disasters or be diverted by astonishing advances in human adaption.”

Of course, we hope for the latter and worry about the former.  History gives us little comfort.

For the time being we shall remain on the sanguine side with regard to this global experiment with increasing debt, zero-bound interest rates, and a monetary/fiscal policy compromise that obfuscates the difference between them.  

As long as this persists, it means financial markets do well, stocks rise, risk assets regain favor, bonds with hedges yield results, and cash continues to earn zero return.

That is now.  It may change tomorrow, next week, next month, next year or not for quite some time.  There is no way to know.  

For the downside from history we return to Vincenzo’s email to me:  

Dear David,

“I invite you to read the last few sentences of the below article from The Lessons of History, by Will and Ariel Durant. It is about how the destruction of the Roman Empire through the taxation channel made people ‘slaves,’ in other words how serfdom emerged.  This is my number one fear for Italy, but I guess France is making the same mistakes, just starting from a lower debt level. You can also find an online version of the book, thanks to Google.

“Rome had its socialist interlude under Diocletian. Faced with increasing poverty and restlessness among the masses, and with the imminent danger of barbarian invasion, he issued in A.D. 3 an edictum de pretiis, which denounced monopolists for keeping goods from the market to raise prices, and set maximum prices and wages for all important articles and services. Extensive public works were undertaken to put the unemployed to work, and food was distributed gratis, or at reduced prices, to the poor. The government – which already owned most mines, quarries, and salt deposits – brought nearly all major industries and guilds under detailed control. ‘In every large town,’ we are told, ‘the state became a powerful employer, standing head and shoulders above the private industrialists, who were in any case crushed by taxation.’ When businessmen predicted ruin, Diocletian explained that the barbarians were at the gate, and that individual liberty had to be shelved until collective liberty could be made secure. The socialism of Diocletian was a war economy, made possible by fear of foreign attack. Other factors equal, internal liberty varies inversely with external danger.

“The task of controlling men in economic detail proved too much for Diocletian’s expanding, expensive, and corrupt bureaucracy. To support this officialdom – the army, the courts, public works, and the dole – taxation rose to such heights that people lost the incentive to work or earn, and an erosive contest began between lawyers finding devices to evade taxes and lawyers formulating laws to prevent evasion.  Thousands of Romans, to escape the tax gatherer, fled over the frontiers to seek refuge among the barbarians. Seeking to check this elusive mobility and to facilitate regulation and taxation, the government issued decrees binding the peasant to his field and the worker to his shop until all their debts and taxes had been paid. In this and other ways medieval serfdom began.”

Thank you, Vincenzo, for this serious response.  Thank you Paul Kennedy for superbly articulating history and issuing clear warnings.  Thank you, dear reader, if you are still with me.  I hope I have provoked some thought.  

Now we will seek another night’s sleep and hope it is not elusive.

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It’s only natural that investors begin to pause after such a strong rally in risk assets (in less than 3 months), and reassess whether it makes sense to stay long risk.  No need to rehash why we have rallied as it’s been a confluence of factors worldwide including better than expected US economic data and a easing of stress in the euro zone.  Nonetheless, JP Morgan addressed this very issue this weekend in an excellent “Q&A”.  Here is an excerpt:

1.The fundamentals are no good. The world economy is at 2%, barely growing, with Europe already back in recession, profit margins peaking, and a decade of fiscal austerity holding back the private sector. –– Agreed that the macroeconomic fundamentals are not enticing. But the financial fundamentals of high risk premia versus falling uncertainty are compellingly attractive and truly at the core of what defines asset price value.

• 2.The rally is just a house of cards built on easy money. When the liquidity music is over, the asset price bubble will deflate and give it all back. –– High risk premia on equities and credit are indeed due to the near-zero yield on cash and safe government bonds, not because equity and corporate bonds are themselves that attractive. But that is how monetary stimulus works. And central banks will not take back this stimulus until the economies and markets can stand on their own feet, which is several years from now. Remember the old adage of “Don’t fight the Fed”. Surely one should not do so when the Fed works in concord with all other central banks in the world.

• 3. Every one is long now. –– Speculative positions in futures and by macro hedge funds clearly show they are aggressively long risk now. At our Paris Conference last week, 2/3rds of our audience said they were long risky assets. But overall leverage by hedge funds remains subdued, and asset allocators have only shallow longs. Retail investors continue to pour more money into safer bonds funds than equities or high yield. The world as a whole has higher than average cash holdings and some 70% of world holdings offer no positive yield after taxes and inflation.

• What trigger is left to push up risk markets to the next level? –– Accepted there is no obvious trigger as there was before EMU Summits or the Greek restructuring. And our economic growth forecasts are in line with consensus. But within our line of thinking, the true surprise, and thus trigger, is no surprises. High risk premia mean the market is priced for risks and thus negative surprises. If these risks, ill-defined as they may be, do not show up, then that is by itself an event that surprises relative to market pricing.

• There remain tons of risks in front of us. The US and Euro governments have simply kicked the can down the road, China is weakening dramati- cally, and Israel will not wait forever. –– Yes, monetary easing and fiscal stopgaps have simply bought time, but time is what is needed to heal wounds. US fiscal decisions will have to await the elections while Europe has a lot of work to do to put together its fiscal compact. The US Administration will want to exhaust all diplomatic tools before making a military decision on Iran, if it ever will. The markets thus face a lull in event risk over coming months, even as long-term uncertainties remain.

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Virgin Money has increased the interest rate on credit cards for some of its customers from 16.8 per cent to 24.9 per cent.

Following criticism of the move, the bank unsympathetically told the customers to either accept the increase, which amounts to nearly 50 per cent, or pay off their balances.

The rates on balance transfers have also been increased, from 18.9 per cent to 27.9 per cent.

According to Virgin Money, the changes are part of a routine review of credit risk, and are unrelated to its takeover of Northern Rock.

Thousands of customers received letters informing them of the increased rates last week, following a review of their performance with the bank and external credit risks factors.

Customers were given 30 days notice of the rises and they have 60 days inform the bank if they do not accept them.

The latest figures from the Bank of England show that lending rates have reached an all time high, despite the base rate being at an all time low of 0.5 per cent.

The average interest rate on a Standard Variable Rate mortgage was 4.16 per cent in January.

This means that the gap between the interest being charged on the average mortgage and the Bank of England’s base rate is 3.66 per cent – the greatest since records began in January 1995.

The average lending rate on overdrafts has increased to 19.5 per cent and the average interest rate on credit cards is 17.3 per cent.

Although lending rates are soaring, savers are receiving extremely low interest rates.

In January, the average interest rate on a deposit account was just 0.2 per cent.

The British Bankers’ Association’s said that the increased gap between the base rate and rates that banks charge borrowers reflects higher funding costs for banks due to the credit crisis and the uncertainty in the euro zone.

Good morning. Here’s what you need to know. 

• Asian markets traded sharply higher overnight as China’s Shanghai SE Composite gained 2.4 percent. European shares are modestly higher and U.S. futures point to a slightly positive open. 
• The European Central Bank has agreed to Greek concessions in a bid to move debt restructuring talks along, the Wall Street Journal’s Stephen Fidler, Matthew Dalton, and Alkman Granitsas report. The ECB will exchange sovereign debt below par value, however it will not take a loss on the move. If advanced, it will mark a key milestone in Greece’s ability to secure its second bailout of €130 billion. Here’s who gets hurt if Greece goes bust.
• German exports declined in December at their fastest clip in almost three years, down 4.3 percent month-on-month to €86.7 billion. Imports also fell unexpectedly to €72.8 billion, down 3.9 percent. Economists polled by Bloomberg expected an increase of 0.8 percent. However, the largest euro zone economy still posted its largest year of exports in 2011, at €1.06 trillion. 
• Rick Santorum rallied in the western United States as he picked up 28 delegates with wins in both Minnesota and Colorado caucuses, as well as the primary in Missouri. Santorum won 44.8 percent of the vote in Minnesota, followed by Ron Paul with 27.2 percent and Mitt Romney at 16.9 percent. In Colorado, Santorum took 40.2 percent of votes. The Missouri primary does not impact delegate selection. These are the 13 elections investors will be watching this year >
• Yahoo announced that four of its board members were stepping down, as the company reshuffles management further. Chairman Roy Bostock, as well as Vyomesh Joshi, Gary Wilson, and Arthur Kern will depart the struggling tech giant. Replacements include former Rovi CEO Fred Amoroso and LiveOps Chairman Maynard Webb. Click here to see the strangest thing about Yahoo’s announcement >
  
• Walt Disney announced that profits rose 12 percent during the first quarter, topping analyst expectations at $0.80 per share. Revenue in the division including ESPN and ABC rose three percent to $4.8 billion. However the company’s film unit was impacted by fewer releases and saw a revenue shortfall.
• Earnings season continues in earnest today, with Time Warner, Visa, and Groupon reporting quarterly results. Already this morning, Time Warner announced earnings per share of $0.94, above expectations, as revenues surged to $8.2 billion during the fourth quarter. Analysts polled by Bloomberg forecast earnings per share of $1.45, and $0.03 for Visa and Groupon, respectively. Here’s everything we’ve already learned from the biggest reporters during earnings season.
• Nokia will cut some 4,000 jobs as it shifts its production to producers closer to its Asian supply chains. Factories in Komarom, Hungary, Reynosa, Mexico and Salo, Finland will be impacted. Last year, sales at the company fell 25 percent to 77.3 million units. Nokia is banking part of its resurgence on its new Lumia line.
• Airlines will be forced to conduct greater inspections of their fleets of Airbus SAS A380s after cracks were found in some planes, the European Aviation Safety Agency says. The aircraft manufacturer has responded that there is a two step solution to address the problem.
• The Mortgage Bankers Association announced mortgage volume surged 7.5 percent during the week ending February 3. That’s a reversal from last week when mortgage applications fell by 2.9 percent. Refinancing activity gained 9.4% during the week. There are no other major economic announcements scheduled in the U.S. 

Bonus: Megan Fox is the new face of Armani’s beauty collection.

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