Wednesday, September 1, 2010

The International Financial Crisis Continues

¹²The International Financial Crisis Continues…

Japan Renews QE
China's Rising Bank Debt
Fresh Flight To Swiss Franc
Time Is Running Out
Irish Debt Under Fire
Commodity Spike Queers The Pitch
US Treasury Yields Fall To Record Low
Europe's €30 Trillion Headache
Drip After Drip Of Deflation Data

Japan Renews QE As Recovery Falters

Japan has launched a fresh monetary and fiscal boost to shore up its faltering recovery and stem the slide into deflation, becoming the first major country to inject further stimulus since the Great Recession ended.

By Ambrose Evans-Pritchard | 30 Aug 2010

Bank of Japan Governor Masaaki Shirakawa speaks to the press Photo: EPA

The Bank of Japan agreed at an emergency meeting to boost its 'special loan facility' by ¥10 trillion to ¥30 trillion (£220.7bn). "We need to watch out more carefully for downside risks to Japan's economy," said Governor Masaaki Shirakawa, who cut off his trip to the Jackson Hole forum in the US. "Several weak US figures came out, while the yen rose and stock prices fell. When we saw this, we decided that we need to take more precautions."

Premier Naoto Kan said Tokyo would tap into its reserve fund for a ¥920bn spending package on jobs and investment. "We want to take swift measures as the second pillar of stimulus to support easing by the bank," he said. The sums are tiny, a sign of Mr Kan's limited room for manoeuvre as public debt reaches 225% of GDP. Rating agencies are already circling ominously.

The economy stalled in the second quarter, growing just 0.1%. Prices have fallen for the past 17 months. Core deflation is running at -1.1%.

The Bank of Japan's move was too timid to stabilise exchange markets. The yen appreciated sharply to ¥84.6 against the dollar. It is once again closing in on a 15-year high.

Julian Jessop, from Capital Economics, said the bank was responding "without enthusiasm" to political pressure to do something about the over-mighty yen. Mr Kan has been calling for "decisive action" to stem the yen's rise, now causing heartburn for exporters such as Toyota and Sony. While the yen has at times been stronger against the dollar in real terms, it is the rate against China's yuan that worries Tokyo. This cross-rate is wildly out of kilter.

Japan's curse is that the yen strengthens in times of crisis as investors repatriate money for safety. Life insurers and pension funds rotate from US bonds back into Japanese bonds as the yield gap narrows, which compounds Japan's deflation woes. BNP Paribas said Japan may have more luck than Switzerland in driving down the currency if it chooses to intervene, since both monetary and fiscal policy are aligned in the same direction. Japan's authorities launched a huge purchase of US Treasuries during the deflation scare from 2003 to 2004 in order to weaken the yen.

Mr Kan would like to see a repeat of such "shock and awe" action but has failed to convince Mr Shirakawa that the risks are worth it. Bank officials fear that a monetary blast might disturb a fragile equilibrium, bringing unwelcome attention to Japan's debts. Haunted by memories of Japan's hyperinflation, the bank is moving gingerly.

Even so, it is the first central bank to start loosening again. While the Bank of England has hinted at more quantitative easing, and the Fed is taking steps to avoid "passive tightening", neither has yet launched a fresh QE.


China's Rising Bank Debt Could Leave Nation Exposed

Moody's rating agency is concerned that China is powering its economic growth by raising the gearing of the banking system, leaving the country exposed if the outlook darkens.

By Ambrose Evans-Pritchard | 30 August 2010

The banks are expanding their balance sheets rapidly through higher leverage— a policy that relies entirely on the continuance of torrid growth. "Pain lies ahead if China's economic growth slows and the banking business model cannot adjust accordingly in time," said Yvonne Zhang, the agency's senior China analyst. Moody's said China Investment Corporation (CIC), the country's sovereign wealth fund, borrowed $8bn (£5.1bn) last week to recapitalise three state-owned banks, using debt rather than genuine equity to boost bank capital.

The agency said that beefing up the banks by this method is "credit negative" for China as a whole: "The increases in assets and equity are artificial and without real economic substance. The increase in reported equity enables the banks to lend more and effectively leverages up the system". The agency does not explore why the CIC is resorting to debt to carry out these transactions, but the practice looks bizarre from the outside and prompts questions over the resources of the fund itself.

Concerns are mounting about the opaque operations of China's banks. The regulator ordered them to carry out a stress test this month based on a 60% fall in property prices. It is probing $1 trillion of local government loans at risk of impairment.


Fresh Flight To Swiss Franc As Europe's Bond Strains Return

The Swiss franc has surged to an all-time high against the euro on capital flight from the eurozone after Irish, Greek, and Portuguese bonds came under renewed fire.

By Ambrose Evans-Pritchard | 25 August 2010

Yields on 10-year Swiss bonds fell to 1.02% as investors flocked into the ultimate safe-haven asset, now outperforming gold. No country in the developed world apart form Japan has ever seen 10-year yields drop below 1%. Rates remained significantly higher during the two great depressions of the 1870s and the 1930s.

Within the eurozone investors turned to German Bunds, pushing yields to an historical low of 2.11%. The search for safety seems driven by swirling mix of fears over a double-dip recession in the US, austerity overkill across the West, and sovereign debt worries on the eurozone periphery. The Swiss National Bank appears to have abandoned efforts to halt the appreciation of the 'Swissie' after losing 14bn francs (£9bn) over the first half of the year in a failed effort to stop money flooding into the country, some of it coming from German citizens in Bavaria opening precautionary accounts.

The franc punched through €1.30 on news that Standard & Poor's had downgraded Ireland to AA-. The rating agency cited concerns that the bank rescue costs may ultimately balloon to €50bn, against government estimates of nearer €25bn. S&P said the public debt would rise to 113% of GDP if the bail-out fund is included on budget books.

Effects of the downgrade ricocheted through the bonds markets of weaker economies. Spreads on Greek bonds rose 40 basis points to 927, higher than before the EU's €110bn rescue. Hans Redeker, currency chief at BNP Paribas, said flows into Swiss franc have been early warning signal at each stage of Europe's debt crisis and should be watched closely. "We may be seeing a rerun of what happened in May," he said.

Phil Jordan from Monument Securites said that even Britain was emerging as a sanctuary as yields fall to a fresh low of 2.84%, though in this case the money is rotating away from the US. "Clients are selling US Treasuries to buy Gilts. The US economic data has been so bad investors are looking for other safe havens," he said. Morgan Stanley said investors are taking a risk buying sovereign bonds at this level, arguing that debt-to-GDP ratios in the developed world greatly understate the true liabilities and aging costs that threat public finances. "It's not whether governments will default, but how, and vis-a-vis whom," said Arnaud Mares in a client report.

There have been plenty of episodes in history where governments use "financial repression" to wriggle out of debts, including Franklin Roosevelt's revocation of gold clauses in US bond contracts in 1934, and Chancellor Hugh Dalton's perpetual debt issue at an artificially-low 2.5% in 1946. As a rule of thumb, countries with a high stock debt opt for stealth inflation, while those facing a financing crunch rewrite the contracts.

Mr Mares said most Western states are in "deep negative equity" and cannot hope to pay their debts. Bondholders have so far been "fully sheltered from loss" through the crisis but this is politically untenable. The rest of society will not suffer austerity forever in order to pay the coupons. The next phase of the crisis will see revenge by all those who have already taken a big hit, or expect to do so: whether under water on their mortgages, unemployed, dependent on health support, or state employees. Democracy will have its way.


Time Is Running Out For The West

The Great Recession has dramatically shrunk the time left for the big AAA states to prevent a full-blown sovereign debt crisis as their demographic time-bomb threatens, US rating agency Moody's has warned.

By Ambrose Evans-Pritchard | 17 August 2010

"Genuinely adverse debt dynamics were only expected to materialise in 15 to 20 years. The crisis has 'fast-forwarded' history, eroding all the time available to adjust," said the group's quarterly Sovereign Monitor. Moody's fears that the US will crash through its safety buffer by 2013 if growth falters (adverse scenario), with interest payments topping 14% of tax revenues. The debt-to-revenue ratio has already doubled in three years to 430%.

The US, UK, Germany, France, and Spain are all at risk of an "interest rate shock", either because they must roll over a cluster of short-term debt (US, France, Spain) or because deficits are so large. Countries that "fail to demonstrate the level of social cohesion required to stabilise debt" will lose their AAA rating. "Intra-generational" conflict between young and old requires careful handling. States that delay pension reform risk spiralling downwards.

Moody's said the world had changed since Europe's debt crisis. None of the large sovereign states can still assume it is credit-worthy. "The burden of proof now falls on governments," it added.

Britain has the safety cushion of long debt maturities, but the structural deficit is causing debt "to grow an unsustainable rate": the UK is clearly one of the weaker countries in the AAA peer group. Moody's expects Britain's public debt to reach 90% of GDP within three years. It warned that any slackening in fiscal tightening by the Government squeeze would lead to a "sharp rise" in funding costs if growth also slowed, with a nasty effect on debt dynamics.

The warning appears to vindicate the Coalition's claim that immediate belt-tightening is needed to restore confidence and head off a gilts crisis where markets would impose harsher measures. The current crisis differs starkly from the "one-off" debt spikes after the Second World War, when young economies were able to outgrow the debt burden. This time the threat lies ahead as the aging crisis drives up pension and health costs on a static tax base. "While the current stock of debt is large, it is dwarfed by the accumulation of future liabilities if policies do not change."


Irish Debt Under Fire On Fresh Bank Jitters

Ireland's borrowing costs have begun flashing warning signs again on fears the full damage from the country's banking crisis has yet to surface.

By Ambrose Evans-Pritchard, In Dublin | 11 August 2010

A protest in Dublin last year against the government?s handling of the economic crisis Photo: AFP/Getty Images

Spreads on Irish 10-year bonds reached 297 basis points over German Bunds on Wednesday amid reports the European Central Bank (ECB) is intervening to shore up Irish debt, a reversal of the bank's plans to withdraw emergency support. The euro fell almost three cents against the dollar from $1.32 to $1.29. Patrick Honohan, governor of Ireland's central bank and a member of the ECB's council, dismissed the bond jitters as yet another spasm by jumpy and emotional markets.

"The spreads are a setback for our hopes of a narrowing to reflect the fiscal credibility of the country. I don't look at them every day but at this level they are ridiculous," he told The Daily Telegraph, speaking at his office in the heart of Dublin. He said critics are failing to recognise the dynamism of Irish exports as the country quickly returns to a current account surplus, or the revolution in public accounts as tax reform kicks in.

"People thought things would take care of themselves, and they have had more than a wake-up call"
— Patrick Honohan, governor of Ireland's central bank

The latest jitters stem from the escalating costs of Ireland's rescue of Anglo Irish Bank. The European Commission revealed this week that it had approved government support worth €24.3bn (£20bn) for the bank, significantly higher than estimates by Dublin earlier this spring. Dr Honohan fumed at the mere mention of Anglo Irish, which brought the country to its knees two years ago in much the same way the Icelandic banks crippled their host state.

"They were egregious, in a league of their own," he said. "If it hadn't been for them the losses would have been manageable. The net cost to the Irish state of recapitalising the banks is €25bn, or 15% to 16% of Irish GDP. It is nearly all the result of Anglo Irish."

Dr Honohan is a poacher-turned-gamekeeper, an arch-critic brought in last year to clean house at the central bank. A professor at Trinity College Dublin, he used to work for both the IMF and World Bank. He had condemned the government just a few months before his appointment in a paper entitled "What went wrong in Ireland".

His long-standing argument is that the genuine Celtic Tiger of the 1990s gave way to a foolish credit bubble over the next decade under "complacent and permissive" bank regulation and the failure of the political class to understand that a small economy on the edges of a currency union must use fiscal policy to prevent overheating. "There was complacency about joining the single currency in a number of countries. People thought things would take care of themselves, and they have had more than a wake-up call," he said.

The cardinal error in Ireland was to stand idly by as the ECB's ultra-low interest rates set off an explosive property boom. Real rates averaged minus 1% for almost a decade. Instead, the government made matters worse by relying on "fair weather" taxes— capital gains, property, and corporate taxes— that created windfall revenues and flattered public accounts, until it all ended with a crash.

Dr Honohan knows as well as anybody that Ireland has little headroom for error. The IMF expects public debt to reach 96% of GDP by 2012, near the tipping point when debt dynamics become unstable. Under Ireland's rescue programme the viable core of Anglo Irish's business will be cut from the wreckage and relaunched as a new entity. Bad debts are already parked at Ireland's National Asset Management Agency (NAMA) at an average "haircut" of 50%.

Antonio Garcia Pascual, at Barclays Capital, said the NAMA strategy initially won plaudits but is increasingly viewed by markets as "a very costly approach". There are growing doubts over the exposure of Irish banks to British property. Fergal O'Brien, chief economist for the Irish Business and Employers Federation, said another threat is creeping up on the banks.

They issued tracker mortgages during the boom at rates that are now underwater. "This has become a big problem. The banks are locked into loss-making contracts," he said. For the past year, Ireland has been touted as the model of fiscal rectitude, proof that countries can pull themselves out of a tailspin if they act fast. It is the laboratory for debt-hangover cures in the eurozone.

The nation has certainly been bold, cutting public wages by 13% (including pension levies) to restore competitiveness. This is known as an "internal devaluation" in IMF parlance, the only option left for a country that cannot devalue its currency. Less clear is whether it can work. The budget deficit seems stuck at 14% of GDP, and unemployment has risen to 13.7%. The severity of the slump is eating away at the tax base. Critics say the country is chasing its tail. [[A death spiral?: normxxx]]

Under the deflation, nominal GDP has contracted by almost 20%. Yet the debt stock has risen. Ireland is uncomfortably close to a classic debt-deflation trap along the lines described by Irving Fisher in the 1930s.

Dr Honohan said the tax take is a lagging indicator. Revenues are "undershooting a little" but there is nothing yet to worry about. Asked about the risk of a Fisherite deflation spiral, he waved his hands in protest and said the country was at no risk of being pushed "head over tail downwards" by the discipline of EMU membership.

Yet a great deal of unhappiness could have been avoided if Ireland's leaders had understood the nature of the game earlier. "The lesson is that if you want to join a currency union with low inflation, you had better not get out of line."


Commodity Spike Queers The Pitch For Bernanke's QE2

Don't be fooled: a food and oil price spike is not and cannot be inflationary in those advanced industrial economies where the credit system remains broken, the broad money supply is contracting, and fiscal policy is tightening by design or default.

By Ambrose Evans-Pritchard | 8 Aug 2010

America's recession has left 8 million without work— something the recovery shows little sign of easing.

It is deflationary, acting as a transfer tax to petro-powers and the agro-bloc. It saps demand from the rest of the economy. If recovery is already losing steam in the US, Japan, Italy, and France as the OECD's leading indicators suggest— or stalling altogether as some fear— the Eurasian wheat crisis will merely give them an extra shove over the edge. Agflation may indeed be a headache for China and India, where economies have over-heated and food is a big part of the inflation index. But the West is another story.

Yields on two-year US Treasury debt fell last week to 0.50%, the lowest in history. Core US inflation is the lowest since the mid-1960s. US business inflation (pricing power) is at zero. Bank lending is flat and securitised consumer credit has collapsed from $900bn to $240bn in the last year. Hence the latest shock thriller— "Seven Faces of Peril" by James Bullard, ex-hawk from the St Louis Fed— who fears US is now just one accident away from a Japanese liquidity trap.

In Japan itself core CPI deflation has reached -1.5%, the lowest since the great fiasco began 20 years ago. 10-year yields fell briefly below 1% last week. Premier Naoto Kan has begun to talk of yet another stimulus package. "The time has come to examine whether it is necessary for us take some kind of action," he said.

In a normal recovery, the US labour market would be firing on all cylinders at this stage. Yet the latest household jobs survey showed a net loss of 35,000 jobs in May, 301,000 in June, 159,000 in July. The ratio of the working age population with jobs has fallen to 58.4, back where it was in the depths of recession.

Over 1.2m people have dropped out the work force over the last three months, which is the only reason why the unemployment rate has not vaulted back into double digits. A record 41m Americans are on food stamps. This is unlike anything since the Second World War. It screams Japan, our L-shaped destiny.

"Unprecedented monetary and fiscal stimulus has produced unprecedentedly weak recovery", said Albert Edwards from Societe Generale in his latest "Ice Age" missive. That stimulus is now fading fast before the private economy has clasped the baton. After digesting Friday's jobs report, Goldman Sachs' chief economist, Jan Hatzius, thinks the Fed will abandon its exit strategy and relaunch QE this week, taking the first "baby step" of rolling over mortgage securities.

Future asset purchases may be "at least $1 trillion". He is not alone. Every bank seems to be gearing up for QE2, even the inflation bulls at Barclays. The unthinkable is becoming consensus.

Into this deflationary maelstrom, we now have the extra curve ball of Russia's export ban on grains. There is a risk that this mini-crisis will escalate if Kazakhstan, Belarus, and Ukraine follow suit, and if the scorching drought lasts long enough to hit seeding for winter wheat next month. But remember, there was a global wheat glut until six weeks ago. Stocks are at a 23-year high. Prices are barely more than half the peak in 2008. The US grain harvest is bountiful; Australia, India, Argentina look healthy.

The Reuters CRB commodity index is no higher now than in April. Last week's commodity scare looks like an anaemic version of the blow-off seen in the summer of 2008. The chief risk is that central banks will panic yet again, seeing ghosts of a 1970s wage-price spiral that does not exist.

In July 2008, Jean-Claude Trichet told Die Zeit that there was "a risk of inflation exploding". As we now know— and many predicted— eurozone inflation was about to fall off a cliff. But acting on Trichet's aperçu, the European Central Bank raised rates. No matter that half Europe was already tipping into recession.

The Western banking system went into melt-down within weeks. The Fed was not much better. It issued an "inflation alarm" in August 2008. Dr Robert Hetzel of the Richmond Fed has written a candid post-mortem in "Monetary Policy In The 2008-2009 Recession", rebuking the Fed and ECB for over-reacting to inflacionista hysteria. They tightened into the crunch.

For those wonkishly inclined, Dr Hetzel said their error was to view the enveloping crisis through a "credit" prism, missing the tectonic issue that the "natural rate of interest" had fallen below the Fed funds rate. Failure to diagnose the problem properly meant that Fed policy may have made matters worse. This is perhaps the best analysis I have ever read on what went wrong, yet it has received scant attention.

Do we have any assurance that central banks have learnt their lesson? Clearly not the ECB, judging from Mr Trichet's ill-judged article for the Financial Times two weeks ago: "Now it is Time for all to Tighten". Much of what he wrote is correct in as far as it goes. Public debt is out of control. Budget stimulus may start to backfire. We are at risk of a "non-linear" rupture should confidence suddenly snap in sovereign states.

Yet he also suggested that half the world can copy the fiscal purges of Canada and Scandinavia in the 1990s, all at the same time, without setting off a collective downward spiral. He offered no glimmer of recognition that the fiscal squeeze must be offset by ultra-loose money. True to form, the ECB is now draining liquidity. Three-month Euribor has risen to the highest in over a year.

John Makin from the American Enterprise Institute described the Trichet argument that collective removal of fiscal thrust can be expansionary as "preposterous and dangerous". Mr Edwards called it "risible". Berkeley's arch-Keynesian Brad DeLong could only weep, saddened that everything learned over 70 years had been tossed aside in a total victory for 1931 liquidationism. "How did we lose the argument," he asked?

Unfortunately, such obscurantism is taking hold in the US as well. Alabama Senator Richard Shelby has blocked the appointment of MIT professor Peter Diamond to the Fed Board, ostensibly because he is a labour expert rather than a monetary economist but in reality because he is a dove in the ever-more bitter and polarised dispute over QE. The Senate has delayed confirmation of all three appointees for the board, who all happen to be doves and allies of Fed chairman Ben Bernanke. The Fed is in limbo until mid-September. So the regional hawks who so much misjudged matters in 2008 have unusual voting weight, and now they have a commodity spike as well to rationalise their Calvinist preferences.

Whatever Dr Bernanke wants to do this week— and I suspect he is eyeing the $5 trillion button lovingly— he cannot risk dissent from three Fed chiefs: one yes, two maybe, but not three. He faces a populist revolt from the Tea Party movement, with its adherents in Congress and the commentariat. And China simply hates QE, which may or may not be rational but cannot be ignored.

Global markets have already priced in the next QE bail-out, banking the "Bernanke Put" as if it were a done deal. We will find out on Tuesday if life is really that simple.


US Treasury Yields Fall To Record Low On Fed's 'QE Lite' Plan

Yields on short-term US Treasury debt have fallen to the lowest in history on mounting expectations of extra stimulus from the Federal Reserve.

By Ambrose Evans-Pritchard | 3 August 2010

Two-year rates fell to 0.52% after a further batch of grim data hinted at a sharp slowdown in the second half of the year. Factory orders fell 1.2% in June, while consumer spending fell flat. The savings rate has risen to a one-year high of 6.4% as Americans adapt to the new era of austerity and build a safety buffer against unemployment. "Households are repaying debt at a rapid clip," said Gabriel Stein from Lombard Street Research. "With an output gap at around 3%, the US economy could move into outright deflation in 2011 for the first time since records began."

The latest figures follow a sharp drop in GDP growth to 2.4% in the second quarter, prompting fears that the economy may stall altogether as the boost from fiscal stimulus and inventory cycle both fade. The data has strengthened the hand of the Fed board led by Ben Bernanke as it pushes for a return to quantitative easing (QE), against fierce resistance from the Fed's regional hawks. A closely-scrutinised article by the Wall Street Journal— described by some analysts as kite-flying by the Fed board— said the bank may announce some form of compromise at its crucial meeting next week, agreeing to roll over bonds purchased during the credit crisis rather than letting them expire gradually as previously planned. This would entail a slow shift from mortgage debt to Treasury bonds.

The Fed would keep its balance sheet steady at $2.3 trillion (£1.44 trillion). The effect would be neutral rather than adding any fresh stimulus. It has already dubbed 'QE lite' by Barclays Capital, as opposed to full 'QE2'. However, Fed watchers say it would be a crucial first step in a broader shift in policy.

The bank has bought $1.7 trillion in bonds. Experts say key governors have been mulling a net increase to stave off possible deflation, pencilling in a rise in the balance sheet to $5 trillion in extremis. Mr Bernanke said on Monday that US states have been "battered" by a budget crisis, forcing them to cull staff. This is holding back recovery. "We need to be careful about tightening too quickly," he said.

Jan Hatzius, chief US economist at Goldman Sachs, said fiscal policy is turning contractionary, draining 1.7% of GDP next year after adding 1.3% in early 2010. This leaves the Fed as the last line of defence. "The disappointing economic data has clearly taken a toll on the confidence of at least a few Fed officials," he said, citing warnings by James Bullard from the St Louis Fed that the US risks a Japan-style deflationary trap. As the keeper of the monetarist flame within the Fed family, Dr Bullard is usually viewed as a hawk.

However, the Fed presidents from Richmond, Philadelphia, Kansas, and Dallas fear that US monetary policy is moving into dangerous waters, stoking asset bubbles rather than letting the debt purge run its course. The risk of 'moral hazard' is growing as markets assume they will be rescued. "I don't think there is any role for the Fed at least in the near term," said Philadelphia chief Charles Plosser last week.

Tim Congdon from International Monetary Research said the Fed has been wasting its powder by using the wrong mechanism to inject monetary stimulus. Instead of buying bonds from pension funds, insurance companies and other bodies outside the banking system, as the Bank of England did with its £200bn gilts purchase, it has been buying from banks. This method has different effects. It has gained less traction because banks have sat on "dead cash". This has not increased the deposits held by companies and households.

"A really powerful way for the Fed to boost the economy is to buy bonds directly from the public, which will increase the quantity of broad money. They won't do that because they have a totally different model and in my view they are confused about the transmission mechanism. If they bought say $1.5 trillion of long-dated Treasuries from non-banks I believe they would get the US out of its liquidity trap very quickly," Mr Congdon said.


Europe's €30 Trillion Headache

European banks have amassed €30 trillion in liabilities and face a serious funding threat over the next two years as authorities withdraw emergency support, according to a new report by Standard & Poor's.

By Ambrose Evans-Pritchard, International Business Editor | 29 July 2010

The rating agency said banks are at risk of a vicious circle as sovereign debt fears and financial stress feed off each other. "Banking sector woes are eroding sovereign credit-worthiness, which is in turn reducing the real and perceived capacity of governments to support weak banks," said S&P.

"The collective funding needs of Europe's banks are vast. The industry is much larger than America's or Asia's. Most of their mortgages and other personal loans stay on their balance sheets and require funding. This contrasts with the US, where financial institutions securitize (these) loans and which do not require balance sheet funding," said Scott Bugie, S&P's credit strategist. Total liabilities are €23 trillion for the eurozone and €8 trillion for the UK, Sweden, and Denmark.

S&P said the European Central Bank's emergency lending had inadvertently created a snare. Its three-month loans have had the effect of concentrating roll-over risk for large amounts of debt. Banks will eventually have to refund these loans in a crowded market, competing with debt-hungry states. "ECB loans have contributed to a shortening of liability maturities. The result is a growing funding mismatch for the European banking industry. This is happening as regulators prepare to introduce tougher liquidity standards. This is one of the greatest vulnerabilities of the industry," it said.

The Netherlands has already ended state debt guarantees, forcing its banks to go the market as bonds fall due. Others are following suit. Roughly €1 trillion of such debt in the eurozone and Britain will come due by 2012. "The need to refinance the maturing guaranteed-debt looms over many banks," said the agency. Stronger banks can cope: weaker ones will be left floundering in "a two-tier funding market".

S&P said Greek banks have seen a leakage of €10bn to €20bn in customer deposits since the crisis began, or 5% to 10% of the total. They are [effectively] shut out of the capital markets. The ECB is propping up the country with €140bn of exposure to Greek debt in one form or another. It has €126bn of exposure to Spain and €71bn to Ireland, mostly in loans to weaker lenders such as Spain's cajas. The exit from this will be a minefield.

The EU's €750bn "shock and awe" rescue has gained time but not conjured away underlying concerns about the fiscal health of the EU states themselves. The report came as the ECB's latest bank survey showed that credit conditions had tightened sharply in the second quarter, with a net 11% of lenders restricting loans. The survey was carried out in late June, after the €750bn rescue but before the stress tests for banks.

"What it shows is that the sovereign debt crisis had a measurable effect on lending," said Silvio Peruzzu from RBS, adding that rebound will lose steam if the banks are unable to boost lending as companies exhaust their cash buffers and start to borrow again. "There is a risk of a double-dip in 2011". Mr Peruzzo said the eurozone is at a delicate juncture.

Germany has been powering ahead, lifting the much of the eurozone with it, but the recovery is not yet entrenched. There are signs of a slowdown in the US and Asia that could prove infectious. The risk is that a renewed growth lapse would put the spotlight back on the austerity policies in Club Med.

"Fiscal consolidations are not a one-off event. They go on for years. If down the line the markets start to question the debt trajectories of these countries, the banking systems will be tested again. There is €1 trillion of private debt in Spain linked to just one asset: property," he said. Much depends on whether the global recovery lasts long enough to lift Europe's weakest states off the reefs, rescuing their banking systems.


Drip After Drip Of Deflation Data

By Ambrose Evans-Pritchard | 27 July 2010

Alan Greenspan (Photo: Reuters)

Today's release on manufacturing activity by the Richmond Fed is pretty ghastly, as you would expect given that the effects of fiscal stimulus are now wearing off at accelerating pace— before the happy handover to the private sector is safely consummated— and given that the structural East-West imbalances that lay behind the global crisis are getting worse again.

The expectations index for the US 5th District is crumbling.

This follows yesterday's horrendous fall in the Texas business activity index from the Dallas Fed, which fell from -4 in June to -21 in July. "Thirty-one percent of firms reported a worsening of activity, up from 22 percent in June," said the bank.

Texas New Orders were -9.6 in July, -8.2 in June, and +15.8 in May.

Capacity Utilization was -0.6 in July, +2.7 in June, and +18.7 in May.

This of course is why Fed chair Ben Bernanke has been giving strong hints of QE2 (helicopters again) if necessary. Forgive me if I am becoming a "leading indicator" bore but these turning points in the cycle are fascinating. The US Conference Board's index of consumer confidence fell again in July to 50.4 after plunging in June.

"Concerns about business conditions and the labour market are casting a dark cloud over consumers that is not likely to lift until the job market improves. Given consumers' heightened level of anxiety, along with their pessimistic income outlook and lackluster job growth, retailers are very likely to face a challenging back-to-school season," said the Board.

This follows the fall in the ECRI leading indicator for last week to -10.5, a level that has always been followed by recession in the post-war era. The Economic Cycle Research Institute is being careful not to 'jump the gun', waiting for 'further confirming data' before issuing a formal recession call that would hurt its credibility if proved wrong by events.

All of this squares with the fall in truck shipments and rail car loadings over recent weeks.

"What we're looking at is an invisible wall, which we've run into here. Which, essentially, as far as I can see, is a typical pause that occurs in an economic recovery," said Alan Greenspan earlier this month.

"I will grant you that this is not a normal economic recovery. We've just come out of what I believe is the most extraordinary and virulent global financial crisis that the world has ever seen."

"I don't know where the end game is. Something has got give here. One possibility is there
[will be] fewer members of the European Monetary Unit," he told CNBC.

The bond markets behaving in a way that is entirely consistent with these leading indicators. Two-year US Treasuries are still near historic lows at 0.63%. The 10-year yield is at 3.03%. Thirty-year mortgage rates have fallen to the lowest ever, which bleeds the profits of banks surviving on the internal "carry trade"— borrowing at super-low short-rates to buy safe agency bonds with a fat yield.

As David Rosenberg at Gluskin Sheff reminds us eloquently every week, the bond markets are telling us that we are already in a deep and intractable depression— which does not preclude Japanese-style rallies, technical recoveries, and bursts of growth, all within a Kondratieff Winter.

I have no idea what assets prices will or will not do. My area of curiosity is the global economy, and where it intersects with political, cultural, and historical forces. But here is a note I received today from Tom Porcelli at RBC Capital Markets that puts uber-bullish earnings rhetoric in a proper context.

It seems like on a daily basis the headlines point to yet another company beating earnings expectations. The tally thus far shows 142 companies out of 172 have surprised to the upside for a significant 8% beat-rate. On the face of it this seems promising.

But the sales figures (i.e. the part that measures organic growth) have been less than stellar. Thus far, they have shown just over
9% growth versus last year's figures. But sales were down nearly -14% in 2Q09— hardly a tough comp to best!

68% of companies have beaten sales estimates, this is hardly anything to get overly excited about. Back in 2Q08, 69% of companies had beaten sales estimates. We all know where the economy headed shortly thereafter.

The numbers should be taken with a grain of salt. Below the surface, the earnings reports continue to confirm what we have been saying— that this recovery is anaemic at best.

In the end, the global macro economy will dictate the outcome.

So watch the Chinese banking system. Watch Japanese exports. Watch OPEC as it keeps cutting output to hold up the oil price. Watch Euribor rates and the continued contraction in eurozone lending to companies. Watch French industrial output. Watch Polish sovereign debt (that's a new one).

Watch the M3 money supply in the US as it contracts at a 10% annualized rate. And for goodness sake watch the Fed Board. Then sit in a deep leather arm-chair with a good Calvados and Cohiba, listen to Bach Fugues, and think.



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The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

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