Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 25 September 2012

The fires are starting to burn again

Neatly summed up by FT – Secession crisis heaps pain on Spain

  1. Catalonia has declared snap elections which are supposed to be a proxy referendum on Catalan independence. A welcome distraction from the debt crisis. Not.
  2. Germany, Holland and Finland are preparing to backtrack on letting ESM assume the Spanish bank bailout burden. This would add about 10% to debt-GDP. Unless the Irish situation repeats in Spain. In which case the total bill would be around 40% of GDP
  3. Budget targets have been missed as the usual consequences of austerity start showing up. Tax receipts fell 4.6% (year-to-Aug) and government spending rose 8.9% (year-to-Aug) leading to a central government deficit of 4.77% of GDP (compared to 3.81% in the previous year). The total deficit is expected to miss the full-year target which was supposed to be 4.4% before being unilaterally revised higher by Rajoy to 5.8% and then negotiated down to 5.3% by European “partners” and then revised up to 6.3% post Merkel ambush in July.
  4. There is unrest with protesters clashing with police in Madrid forcing them to fire rubber bullets. With unemployment at 25% and youth unemployment at 53% (next only to Greece) these clashes aren’t going to be isolated incidents.   

1.      A funding gap of €30bn has seemingly opened up. Up from €20bn previously estimated which was already twice as bad as previously estimated. Mein gott.
2.      And the IMF seems to be playing hardball and pressing for OSI as its optimistic targets get blown by reality again.


  1. Lawyers are examining whether firing the Dra-zooka will be an infraction of the prohibition against direct state funding (Article 123 TFEU).
The fires are starting to burn again. Or rather the flames are being noticed again. Quelle surprise.

Saturday, 22 September 2012

Singh gets his mojo. Yeah right.

The hopium dealers are falling over themselves to re-peddle the India story just as the China one is souring. Thus the headlines in FT “Manmohan gets his mojo back at last” along with the Economist proclaiming that “Manmohan Singh has rediscovered his vim”. The beloved barometer of hopium addicts, i.e. the stock market, duly rose to a 14-month high.

Amidst all the cheering a puzzled Indian might well ask the cause of this exuberance. It turns out that there are several causes.

First, the hike in the price of diesel leading to reduced subsidy burden on the government budget. This is supposed to be a start towards a more reformist agenda. One has to admire the spin. The last time diesel prices were raised was in June 2011. With oil prices roughly where they were and the rupee depreciating by 18% against the dollar since then, the subsidy burden was unsustainable. It is akin to handing over one’s wallet to a mugger and then trying to portray it as “charity”. In any case, the hike nets out to zero at the aggregate level since government spending is replaced by consumer spending on fuel.

Second, the much touted opening of the retail sector to majority foreign-owned firms is supposed to inject dynamism into both agricultural and retail sectors. However, the important caveat that has been missed is that the implementation of this decision to allow majority foreign-owned firms into the retail sector is left to the states. A stroke of genius which would be wholeheartedly approved by Sir Humphrey Appleby. A decision has seen to be taken when in reality the decision has been delegated to another level of administration. Apart from the obvious costs imposed by an additional layer of bureaucracy and permission requirements, the fact that some states can disallow foreign firms means that operations may not achieve scale and supply chains may remain fragmented. Thus the biggest advantages of an organised retail sector are lost. It is too early to celebrate this as a game changing, mojo rejuvenating move. That is if the fragmentation of decision-making power and added political uncertainty is to be celebrated at all.

Third, additional foreign investment has been allowed in the aviation sector. Foreign carriers can now buy upto a 49% stake in domestic carriers. The desire of foreign airlines to invest is very clear as the following excerpt from a LiveMint news article shows.

Foreign carriers were noncommittal. Lufthansa said it has no investment plans. “Lufthansa has no plans to invest in any Indian carrier,” the carrier said in a email reply. British Airways South Asia regional commercial manager Christopher Fordyce said his airline was bullish on India and keen on investing in the country. “However, we are not considering any investment in Indian carriers at this point of time though India is a very important market. Also, we are very positive about liberalizing the airline industry,’’ he said. Etihad Airways was upbeat about the announcement. “Etihad Airways has identified equity investments in other airlines as an important evolution of our successful partnership strategy,” the airline said.

Translation: Good job of getting the mojo back old chap. Excuse me I’m getting a call on the other line.

By the way, this decision is absolutely not indicative of crony capitalism as the government’s convoluted and laboured logic makes clear. “Denial of access to foreign capital could result in the collapse of many…domestic airlines, creating a systemic risk for financial institutions, and a vital gap in the country’s infrastructure.” One doesn’t know for sure if the mojo is back but the brain certainly isn’t. The only positive is the hope that instead of the government, some clueless foreigner is going to bail out a struggling domestic airline.

Fourth, FDI limits in broadcasting have been raised to 74% and in power trading exchanges to 49%. This is probably the only measure where investment may lead to development and jobs.

Finally, disinvestment in PSUs (Oil India Ltd, MMTC Ltd, Hindustan Copper, National Aluminium Co.) is supposed to signal the virility of the 1991 liberalisation era is back. Once again spin disguises the reality that family silver is being sold to fund a burgeoning budget deficit. With national elections in 2014, an embattled ruling party cannot afford a downgrade to junk status and ensuing financial crash. Therefore the need to disinvest and make budget numbers appealing enough for Moody’s and S&P. Moreover, foreign investment or private investment in government-owned enterprises does not lead to any efficiency gains. TCI’s woes with Coal India Ltd. make it very clear that private investors do not have any say in managerial and strategic decisions. PSUs will continue to be run to fulfill the objectives of the government and shareholder value maximisation is not one of them.

As for the vote of confidence by the stock market, the graph below makes it clear where the money has come from. Foreign Institutional Investors (FIIs) have invested $1.67bn in the month of September with a whopping $1.15bn of that coming in the four days after Mr. Singh apparently found his mojo. In stark contrast domestic mutual fund investors have withdrawn $323m in September. Most of it ($250m) was withdrawn in the four days following the “reform” announcement. Do the foreigners know something that the locals don't?

Source: SEBI, NSE

The exuberance may be linked to Ben Bernanke and Mario Draghi’s promise of supplying mojo pills for investors ad infinitum but risking more than a billion dollars only on the hope of an 80 year old getting his mojo back is a bit irrational.

Thursday, 13 September 2012

Employment in dire straits prompts Ben to print money for nothing

Caution: Written in a mood of bemused anger. Reader discretion is advised before proceeding further.

I certainly read Ben Bernanke wrong. I gave him too much credit for circumspection and he turned out to be a maniac. Today’s FOMC decision highlights the boy with the hammer syndrome that he’s suffering from. To the Chairman with a monetarist ideology, all problems are monetary. As pointed out earlier, QE hasn’t achieved much and isn’t going to either. If printing money strengthened an economy Mugabe would be presiding over an economic superpower.

In any case there is no point in ranting about Ben’s decision to boldly go where von Havenstein has gone before. Analysing the impact is more interesting. Three main points come to the fore.

The first point is about the ambiguous nature of the action – $40bn a month until the labour market improves “substantially”. Even the press conference did not clarify this point. All Ben said was that employment has to come down in a “sustained” way. This effectively means that $40bn-a-month or more is going to be printed until the Chairman is satisfied. Or deposed at the end of his term. However, it also means that every data point and every statement of every official is going to be scrutinized minutely and interpreted differently. Kudos for injecting more uncertainty into an already uncertain market.

Secondly, the inflation part of the Fed’s mandate has been thrown out of the window. The explicit statement that the Fed will remain accommodative for a “considerable time” after recovery makes it crystal clear. The mention of price stability in the statement is mere tokenism. Wasn’t Greenspan’s ‘too low for too long’ policy which got us into this mess in the first place? The law of unintended consequences is clearly not consequential enough for the gurus of the Federal Reserve (Lacker exempted).

The third point concerns the effect of Fed actions on the supply of safe assets. By withdrawing agency-MBS onto its balance sheet it reduces the supply of safe assets in the market. This is clearly intended as the Fed wants the funds to go into risky assets and drive growth. (Side note: Unfortunately there was once an economist called Keynes who cogently pointed out why it may not happen and indeed why it didn’t happen during the Great Depression. Unfortunately he’s considered quite unfashionable in the exalted monetary circles that Ben and company move in). The safe asset supply will be further curtailed due to the impending fiscal cliff which will reduce the deficit and hence UST issuance. The effects of these are not easy to analyse. Market distortions such as rising delivery failures are just one aspect. What happens if a shock leads to an investor rush into safe dollar assets? Certainly one to watch and ponder.

The markets are unsurprisingly jubilant but it’ll be interesting to see the longer term reaction to the consequences of what is possibly the last throw of the monetary die. (I use ‘possibly’ because I don’t know if Ben’s next step to nudge unemployment into a significant and sustained downtrend would be to buy houses outright). 

Wednesday, 12 September 2012

Constitutional Court was cool. Problem solved?

Another hopium shot went in as the German Constitutional Court kept the party going. 

Overall it is not a game changer. In fact by making sure that any increase in bailout bazooka's ammo has to be decided by the Bundestag, the Constitutional Court has made future bailouts more difficult. German public opinion isn't going to countenance any further cheque writing. Moreover, it is also going to make sure Germany continues imposing its austerity-led-growth policy. It's a slow burn. 

So Draghi's OMT is still the only line of defence. Now if only Rajoy would accept paramountcy.

On the judgement, looking past the headlines, some inferences (with the supporting judgement text below):

1. Joint liability has been ruled out. With a paid-in capital of €80bn this means headline firepower of €500bn is exaggerated unless one believes that peripherals guaranteeing to pay for each other’s and their own future bailout is credible.
Judgement 1: “…no provision of this Treaty may be interpreted in a way that establishes higher payment obligations for the Federal Republic of Germany without the agreement of the German representative”

2. Bundestag has to be kept informed. Alas, elected representatives who have to listen to ignorant public opinion will have to be told of technocratic decisions to sink great amounts of the public’s money into an undertaking of great advantage.
Judgement 2: “…the provisions…establishing the European Stability Mechanism do not stand in the way of the comprehensive information of the Bundestag and of the Bundesrat”

3. ESM cannot enhance its firepower without German approval. Just in case the ESM MD was thinking of doing a Draghi.
Paragraph 195: the relevant factor for adherence to the principles of democracy is whether the German Bundestag remains the place in which autonomous decisions on revenue and expenditure are made, including those with regard to international and European liabilities…If essential budget questions relating to revenue and expenditure were decided without the mandatory approval of the GermanBundestag, or if supranational legal obligations were created without a corresponding decision by free will of the Bundestag, parliament would find itself in the role of mere subsequent enforcement and could no longer exercise its overall budgetary responsibility as part of its right to decide on the budget.”

4. Germany still has oversight and controls the purse strings.
Paragraph 198: “…no permanent mechanisms may be created under international treaties which are tantamount to accepting liability for decisions by free will of other states, above all if they entail consequences which are hard to calculate. The Bundestag must individually approve every large-scale federal aid measure on the international or European Union level made in solidarity resulting in expenditure. Insofar as supranational agreements are entered into which by reason of their scale may be of structural significance for parliament’s right to decide on the budget, for example by giving guarantees the honouring of which may endanger budget autonomy, or by participation in equivalent financial safeguarding systems, not only every individual disposal requires the consent of the Bundestag; in addition it must be ensured that sufficient parliamentary influence shall continue to be made on the manner of dealing with the funds provided.”

5. But Monti and Rajoy can hope to repeat their ambuscade as Merkel has the power to loosen those purse strings (absent a backbench revolt).
Paragraph 201: “When examining whether the amount of payment obligations and commitments to accept liability will result in the Bundestag relinquishing its budget autonomy, the legislature has broad latitude of assessment, in particular with regard to the risk of the payment obligations and commitments to accept liability being called upon and with regard to the consequences then to be expected for the budget legislature's freedom to act; the Federal Constitutional Court must in principle respect this latitude. The same applies to the assessment of the future soundness of the Federal budget and the economic performance capacity of the Federal Republic of Germany, including the consideration of the consequences of alternative options of action.”

6. Banking license is certainly not going to happen. CC Monti
Paragraph 245: “It can be left open whether the European Stability Mechanism’s taking up of loans with the European Central Bank is already precluded by Article 21 (1) TESM, which merely provides for borrowing “on the capital markets”. As an internal agreement between European Union Member States, the Treaty establishing the European Stability Mechanism must at any rate be interpreted in conformity with European Union law. As borrowing by the European Stability Mechanism from the European Central Bank, alone or in connection with the depositing of government bonds, would be incompatible with European Union law, the Treaty can only be taken to mean that it does not permit such borrowing operations.

7. No enhancing firepower by leveraging off the ECB.
Paragraph 247: “A depositing of government bonds by the European Stability Mechanism with the European Central Bank as a security for loans would also infringe the ban on the direct acquisition of debt instruments of public entities. Here, it can remain open whether this would constitute a direct acquisition of debt instruments of state issuers on the primary market or whether after their intermediate acquisition by the European Stability Mechanism, it would be tantamount to an acquisition on the secondary market. For an acquisition of government bonds on the secondary market by the European Central Bank aiming at financing the Members’ budgets independently of the capital markets is prohibited as well, as it would circumvent the prohibition of monetary financing”

Tuesday, 11 September 2012

Die Bear Die!

The first week of September has made bearishness deeply unfashionable and bears an endangered species. After all what’s not to feel upbeat about? Draghi unveiled the bazooka, Ben is about to discharge his again and the German Constitutional Court is widely expected to ignore the law. If three strikes were not enough, China unveiled a trillion yuan stimulus to keep its economy unbalanced.

As the last quarter approaches and underweight and underperforming fund managers desperately try to justify their fees, pessimism has been banished and pessimists subject to ridicule.

Additional vertical thrust has been provided by the usual momentum chasers and capitulating shorts.

For those who want to be millionaires, the big question is what to do?
  1. Buy
  2. Buy some more
  3. Sell
  4. Short sell
As for the lifelines: The audience is divided between A and B; your friend knows as much as you; and 50:50 gives A and C.

While you ponder this over, remember you can always walk away with your money.

Meanwhile two new facts to consider before answering:
  1. As pressure is lifted and Spanish bond yields return to “normal” levels, Rajoy wants the money but only if it doesn't come with preconditions. ECB’s “Italian mistake” now playing in Spanish theatre?
  2. As pressure mounts on Greece, it counterattacks by setting up a working group to tally how much Germany owes in outstanding reparations for Nazi war crimes. What if we just tear up the TARGET 2 bill and call it even?

Thursday, 6 September 2012

Empty OMT

The leaks were spot on. OMT (Outright Monetary Transactions) is nothing but SMP Mark II as the press release makes clear. I’ve already talked about the problems with the “new” plan in yesterday’s post (Draghi about to unveil "new" old plan). Before getting pumped full of hopium, putting in buy orders and clinking glasses full of liquidity, some additional points to consider:

Conditionality I, aka “I’ve got the bazooka but someone else has the trigger”

EFSF/ESM programme needs to be in place before OMT can be activated. The problem: Conditionality => Austerity => Economic collapse (based on Greece and Portugal). No wonder Rajoy is hesitant to submit. Rather than being an effective instrument of intervention, OMT has become contingent on politics thus hindering its ability to be deployed quickly if at all.

Conditionality II, aka “Fire and forget”

Non-compliance with imposed conditions will lead to termination of the programme. Very strict and disciplined Mr Draghi. Just one question, what happens to the bonds already bought? Suppose ECB buys €100bn of Italian debt and then Berlusconi traipses into power and Bunga-Bungas the austerity measures. Will you:
  1. Double down
  2. Sell into a cratering market without regard to your dodgy assets/capital ratio
  3. Stage a coup
  4. Resign to take a professorship at a non-European university and let Jens handle it
Also we’ve not heard the last of the Bundesbank. Draghi’s “near-unanimous” decision, i.e. ‘my way or the highway’ will have the German sound money establishment up in arms. Die Welt has already proclaimed the death of the Bundesbank. Given BuBa’s standing in the eyes of the German public, a reaction by them will not be ignored by Merkel especially before the 2013 elections.

Despite the trumpets today the battle is far from over. The proof of the bazooka is in the firing.

Wednesday, 5 September 2012

Draghi about to unveil "new" old plan?

Tomorrow is D-Day. The leaking ship that is the European Union has so far caused the market to be hopeful and upbeat.

Today’s scoop which caused a sharp reversal in EUR/USD and other risk assets was the Bloomberg article “ECB Plan Said To Pledge Unlimited, Sterilized Bond-Buying

This quote from the article sums up the current logic-free market [emphasis mine]:
“For the moment, the focus really is on the word ‘unlimited,’ which, if indeed affirmed by Draghi at tomorrow’s meeting, would constitute a new step in the ECB’s rhetoric,” said Thomas Costerg, an economist at Standard Chartered Bank in London. That would “send a powerful signal to the market.

First, are investors going to risk their capital based on rhetoric? (Don’t answer that, it’s rhetorical)

Second, ‘unlimited, sterilised’ is an oxymoron. Sterilisation of bond purchases introduces a limit to the amount of purchases which can be made. Since sterilisation involves ECB withdrawing cash from the Eurozone banking system, it can only be done to the extent that Eurozone banks have excess cash. For example, consider the extreme case where Eurozone banks have no excess cash on the balance sheet. Then any selling of sovereign debt to the ECB by foreigners will lead to a sterilisation failure since the Eurozone banking system will not have cash/cash equivalent to put on deposit. Banks would have to sell assets on their balance sheet to free up cash to put up for ECB deposits. Even though we are not at such an extreme since banks have cash and are hoarding it due to uncertainty (but maybe not the Spanish), large scale bond buying is actually going to worsen the situation by causing further asset sales and cash hoarding by banks. Even if selling to the ECB is purely by Eurozone banks, the limit to purchases is the total amount of sovereign bonds held by the Eurozone banking system. 

In any case ECB intervention will not solve anything unless net cash holdings left after sterilisation are used to buy new issuance of sovereign bonds. However since net cash holding remains the same before and after purchase due to sterilisation, success depends on the cash being redistributed to willing buyers. Or those who have currently have cash changing their mind about buying peripheral sovereign debt. The latter is unlikely to happen unless holders of cash are swayed by "new" rhetoric. Willing buyers would likely be domestic banks which leads to strengthening of the vicious sovereign-banking loop. A most unfortunate unintended consequence. 

In the end, ECB intervention will only transfer credit risk from commercial banks and private investors to the central bank, in effect a backdoor bailout. Moreover, as pointed out above, it will enable non-peripheral European banks to dump their peripheral holdings and further withdraw from the periphery. A result contrary to what Draghi hopes to achieve. Indeed, data on rising domestic holdings of sovereign debt in the periphery despite SMP show that ECB bond market purchases lead to foreigners and non-domestic (i.e. non-peripheral) banks to exit first.

Third, is it really a “new step” since the SMP is (was?) also ‘unlimited’ without any cap on purchases? Further, the SMP after buying in excess of €200bn (standing at €209bn currently) was unable to have any significant lasting effect on bond yields or on crisis resolution. 

Fourth, in all other aspects too it seems to be no different from the SMP. The plan according to Bloomberg and FT will:
  1. Not have any public cap on yields – Same as SMP
  2. Only focus on government bonds – Same as SMP
  3. Target short-dated maturities of upto 3 years – Subset of SMP
  4. Drop preferred creditor status – SMP never had explicit preferred creditor status either. And Europe has shown that in a crisis promises and law cannot be trusted as reliable guides to future conduct. It is highly unlikely that the ECB voluntarily submits to an equal haircut when a peripheral default threatens to wipe off its capital. Of course this ‘pari passu’ pledge is made with the assumption that such a scenario cannot happen. This is the same hubris we’ve seen so far: ‘We have no plan B because our plan A will work’. Since 2010 this has resulted in one half-witted plan A after another.
So Draghi, after all his blustering, is just going to re-announce the SMP. Rather, just announce the resumption of the SMP by another name. What springs to mind is not “bazooka” but “Bashi Bazouk” (quoting Captain Haddock).

Monday, 3 September 2012

What does September bode? Part - III


3. China will save us.

This is the most bizarre hope in my opinion. I’d made the case earlier (Red Flags Over China) about how futile it is to hope that a centrally-planned economy built on exports and marked by extreme wealth inequality where a large proportion of the population is still dirt-poor is suddenly going to turn around and rescue the west by becoming a broad-based consumer-led economy.

Since a lot of the facts have already been pointed out in the 1st August post referred above, I’ll stick to the new evidence which has come to light since then.


  1. The latest Chinese PMIs, both official and HSBC, inject a dose of pessimism. HSBC China manufacturing PMI stated: “Manufacturing sector operating conditions worsened at the sharpest rate in 41 months”. The official PMI slid to a nine-month low of 49.2. Graphs 1 & 2 below.
Graph 1: HSBC China Manufacturing PMI
Source: HSBC, Markit

Graph 2: Comparison of Official and HSBC China Manufacturing PMIs

  1. The Shanghai Composite is below the level it reached in February 2009 (Graph 3). If the economic prospects are so rosy then why aren’t the locals piling in?
Graph 3: Shanghai Composite
Source: Yahoo Finance

  1. After many predictions of a vertical rise in steel consumption, the Chinese steel industry is coming down with a bad post-stimulus hangover. Iron-ore prices have already crashed through the once unassailable $110/tonne level. Now the ripple effect of bad loans on bank books has started.
  2. Such excess may be the reason why Chinese leaders have been restrained in unleashing another round of stimulus.
  3. Further complicating matters is the foreign currency outflow out of China which is automatically creating a contractionary monetary policy. Though for the time being, PBoC still has room to manoeuvre and neutralise this effect.

The hope that Chinese demand will save us, failing which a Chinese stimulus will surely save us is false. The Chinese economy will not experience an immaculate transformation into a consumption-led economy from an investment and export-led one. Bulls in China shop may find they are liable for damages. Therefore, commodities and economies dependent on them and China (eg. Australia) are in a precarious position. 

A word of caution for investors before they plunge in

Even though the market’s hopes for a miracle may be in vain and policy actions may have only a fleeting effect, we must remember Keynes dictum that the market can be irrational for longer than one can be solvent. Just as faith in squiggly and straight lines often makes a technical analyst’s predictions self-fulfilling, similarly faith in the omnipotence of central bankers and policymakers can cause markets to run away from fundamentals. Moreover, the well-flagged dangers of September may have already caused the faint-hearted to flee. A rally will cause them to return for fear of missing out and hence reinforce itself. Since the crisis began in 2007 there have been many periods of such "astonishing" rallies in various markets. However, fundamentals always reassert themselves and bigger the rally, harder the subsequent correction.

The suitably positioned long-term investor can weather the irrationality while the short-term speculator must tread carefully. Paraphrasing Mark Twain, ‘September: This is one of the peculiarly dangerous months to speculate in markets. The others are July, January, October, April, November, May, March, June, December, August, and February.’

What does September bode? Part - II

2. Draghi will save us


Any ECB action will require the imposition of strict conditionality. It may also require ESM/EFSF acting in concert. There is opposition both to ECB action and to acceptance of strict conditions. Moreover there are the usual political disagreements on EFSF/ESM role and deployment.

As politicians fiddle and squabble over everything economic conditions continue to deteriorate in the Eurozone. The malaise is no longer confined to the peripherals. France has been moribund for a long time and now Germany’s economy is heading south as well. In addition, optimistic growth, revenue, budget and deficit targets for bailed out countries were missed as usual. Lack of a solution has spooked the private sector and European banks are pulling back into their own territories. A solution requires more than printing money. 

Facts and Analysis:

  1. Draghi’s promise of quasi-monetisation came with strings attached but was conveniently ignored by the market. He stated (emphasis mine), “In order to create the fundamental conditions for such risk premia to disappear…governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist – with strict and effective conditionality in line with the established guidelines. The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed.”
  2. There is considerable disquiet in the Bundesbank over Draghi’s policy with reports that Jens Weidmann considered resigning over the issue.
  3. There is opposition from Germany to granting ESM a banking license. This severely limits the firepower which can be deployed for bond market purchases. Without a banking license the brunt of bond buying will fall on the ECB deepening the schism between easy and hard money camps.
  4. Showing that in Europe what is agreed is not really agreed, EU banking supervision plan has hit resistance with Brussels pushing for ECB to regulate all banks against German and ECB’s own opposition.
  5. Pan-European supervision may be moot as the nationalisation of the banking sector continues apace. Northern banks continue to withdraw from the periphery and peripheral banks become more exposed to the home country.
  6. Amidst the talk, the economic situation across Europe continues to deteriorate. The two biggest economies are foundering.
    1. Germany: “German private sector output falls at a faster rate during August. Renewed services contraction offsets slower drop in manufacturing activity.
Source: Markit 

    1. France:
      1. PMIs have improved but are still stuck in contractionary territory. Employment is still trending down. (Graphs below)
      2. Banking troubles aren't over as CIF becomes the latest recipient of government bailout.
Source: Markit

Source: Markit 

  1. Decline in peripherals proceeds unabated.
    1. Spain:
      1. The regions are lining up for federal bailouts. After Catalonia’s €5bnValencia is poised to ask for €4.5bn (higher than previously expected €3.5bn). Apparently Andalusia is also lining up.
      2. Banking is not fixed as shown by Bankia’s €4.4bn loss released on late Friday evening (convenient timing). NPL’s jumped up and client deposits fled.
      3. As flames rise higher, Rajoy is still hoping for a “condition-lite” ECB intervention. This is despite Asmussen stating that any ECB help must come with strict conditionality and ECB must not repeat the bond buying “mistakes” with Italy last year.
      4. Amidst the political brinkmanship deposits are fleeing the Spanish banking system. ECB data showed a drop of €74.2bn in private-sector deposits in the Spanish banking system. The biggest decline since the series began in 1997.
      5. Economic decline continues with the latest manufacturing PMI showing that output fell for the 16th successive month.
    1. Greece:
      1. The economy continues to head south. GDP contracted by 6.5% annualised in Q2 making IMF-EU assumptions of 4.7% contraction look positively rosy. Unemployment is at a record 23.1% with 55% youth unemployment.
      2. The government has yet to agree to the details of the budget plan. The quote from Venizelos says it all, “We didn't get into details about the austerity measures. This will be done by parties' representatives during the following days, and then there will be another political leaders' meeting.”
      3. More time for the meetings may not be forthcoming. Merkel was non-committal on Samaras’ pleas of more time to implement cuts. However, other German politicians were not as obliging. Volker Kauder, Merkel’s party’s parliamentary leader stated that “neither thetime nor the content can be renegotiated” and Schauble refused to “throw money into a bottomless pit”.
      4. Public opinion in Germany is increasingly anti-Greece. Nearly half the respondents in the latest poll believe that Greece will never be able to reform its economy to free itself from international assistance.
    1. Portugal
      1. Away from the limelight, Portugal is seeing austerity work its magic. Tax revenue dropped 3.5%. Laughably the IMF/EU expectation was for a 2.6% increase.
      2. Budget deficit for 2012 at 5.3% is expected to miss troika target of 4.5%. But it is not a problem as the troika has indicated that it will relax the target in light of a better than expected reduction in external deficit.
      3. Unemployment has increased to a record 15%.
    1. Cyprus: Budget deficit is going to be 4.5% as opposed to the forecast of 3.5%.
    1. Ireland:  Schauble poured cold water over Irish hopes of palming off their bank debt guarantees to the EFSF/ESM. But the Irish economic engine is the one bright spot in peripheral land with its slow grind towards recovery. Whether it can sustain is another question.
    1. Italy
      1. GDP contracted by 0.7% for the fourth successive quarter. The good news was that it beat expectations of a 0.8% decline.
      2. Latest manufacturing PMI (September) was the lowest since October 2011. It showed employment and new orders falling faster.
      3. Italian politics is reverting to normal as elections loom in the first half of next year.
  1. To underscore that the ‘Germany vs the rest’ narrative is facile and wrong, Netherlands is following Finland into increasing Euroscepticism.
    1. Dutch elections are likely to deliver a government unsympathetic of bailouts. The socialists under Emile Roemer have gained in popularity and are expected to win or come second in the election. Unlike the international solidarity of the Comintern, they want to stop bailouts and use that money for the Dutch. Incidentally, they voted against the bailouts of Spain and Greece and the ESM.
    2. Dutch manufacturing PMI rose in August but still remains in contraction territory at 49.7. Importantly output and employment continued to fall. This is not an economy where citizens will appreciate largesse to indebted peripherals.

An entire battalion of tanks is slowly moving towards Draghi, the lone bazooka gunner on the hill. Even as he tries to take aim, he is being peppered by shots from his own side. Since this is not a Hollywood movie, the chances of Draghi unilaterally saving the Eurozone are slim. Moreover, the expectations raised by Draghi's fighting talk may be disappointed. 
Sovereign defaults may be avoided by the expedient of short-term/T-bill issuance repoed with ECB (a path blazed by the Greeks) but the Euro rally is unlikely to last for much longer. Short-term bonds and CDS spreads may benefit due to intervention but long dated bonds are an iffy investment. 

Continue to Part - III

Sunday, 2 September 2012

What does September bode? Part - I

The summer is officially over and if the pundits are right then the season of doom and gloom should have started from Saturday, 1st of September.

On cue the Chinese manufacturing PMI came in below expectations and at a 9-month low signalling contraction in the world’s second largest economy. But markets have consistently shrugged off all fearful prognostications and data to rally over the silly summer season. Is September going to be any different?

To answer the question, we have to follow what a famous detective once said, ‘Examine the facts Watson’. The rally over the silly summer (since the beginning of June) has been based on three shots of hope.

  1. Ben will save us.
  2. Draghi will save us.
  3. China will save us.
Let's take each hope in turn.

1. Ben will save us

  1. Bernanke’s statement “Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labour market conditions.” is nothing new. Ever since the crisis the Fed has stated that it will be accommodative to promote recovery.
  2. US data has been better than expected since the last FOMC meeting. In addition, since the publication of the FOMC minutes which triggered the latest market rally, data show an improvement with many releases beating expectations (Table below).

Existing Home Sales
Improving, below expectations
Initial Claims
Continuing Claims
New Home Sales
Durable Goods Orders
Durable Goods ex-Transport
Improving, below expectations
Case-Shiller 20-City Index
Initial Claims
Continuing Claims
Improving, below expectations
Personal Spending
Improving, below expectations
Chicago PMI
UMich Consumer Confidence
Factory Orders
Source: Yahoo Finance
  1. Labour market remains moribund (as seen by the claims data above).
  2. No action on the horizon to avert the looming fiscal cliff.
  3. Republican ire at the Fed’s easy money policy is increasing with Romney categorically rejecting his re-appointment if he wins the Presidency. An opinion piece in the FT by Senator Corker, a member of the Senate Banking Committee, assailed Bernanke and asked him to show “some humility”.

The hope that Ben will save us is based more on faith than on facts. As I’ve argued earlier, in the face of a liquidity trap the Fed is powerless. QE by itself is going to do nothing for employment. But that is not going to stop Bernanke and his merry men from trying to beat von Havenstein’s record for easy money policy. The question for those transfixed at the short-term is whether Bernanke announces QE3 at such a politically sensitive juncture given the political opposition and the improvement in economic data. The answer is that he is likely to disappoint the faithful.

In spite of the likely near term disappointment, the good news is that the US economy seems to be on the mend (maybe not fast enough for impatient policymakers but then years of excess cannot be corrected in months). The bad news is that fiscal contraction due to the looming fiscal cliff needs to be averted for the economy to at least stay on the current anaemic growth trajectory. With a Vice Presidential candidate spouting Randian gibberish and polarised electorate and Congress, the chances of a compromise to avert the cliff appear slim.


Market expectations regarding QE3 are likely to be dashed unless the Europeans force Ben’s hand. Assets which have rallied on QE3 hopes look vulnerable. If you've bought the rumour, be ready to sell the fact. 

Continue to Part - II