how to fix europe

The world’s a happy place again. After racing towards the precipice at astonishing speed, we’ve backed away again even more quickly. People are pointing to all sorts of things: the global central bank puts finally kicking in, the economic data (rather than the sentiment data) holding up better, the mythical European plan to save the Euro from Europe…but it really boils down to the one thing that matters: positioning. In the rally everyone had risk on trades, in this selloff everyone has risk off trades. We’re now back to some pretty key levels, and the question is how much this week’s risk on move has cleaned out the brave souls who’ve had positions. For mine I’m fading this move, but if we get S&P pop up through 1230 all bets are off. For the first time in this move the Eurodollar futures rallied overnight as well, which is a tick for the risk on crowd, but are still at pretty distressed levels, which is a tick for the risk off crew. Also last night we had several European banks biting the bullet and tapping the ECB’s US$ funding lines, with $500mio going for 1 week and $1.4bn going for 3 months…at 1.1% (which is more like 1.3% when you take haircuts into account), that’s a wopping premium to 3m Libor. And the T10 auction last night was very poor, following the poor bund auction earlier…again signs that positioning remains light and things are still dislocated.

Price action today in Oz has been telling: a stronger than expected employment report has been enough to knock the suffing out of the IB and bank bill strips, as the market prices for an RBA that’s more neutral than easing. The curve has flattened but the market found a wall of buying in the 3s down around 96.10, with 96.07 a big support level. The Aussie dollar shot up to as high as 1.0230 but has peeled back off half a cent in short order too. That’s because domestic news doesn’t really matter all that much right now – the RBA has already said that if CPI is behaving itself then offshore events will dictate where and when rates go here.

Internationally the market seems to be giving credence to Merkozy’s plan to have a plan within the next few weeks…but Masnick’s law of Europe says they will always find a way to disappoint. The FT has not one but two good articles on this…first up Martin Wolf: The broad consensus of the world’s policymakers and commentators is that the eurozone must now do the following: divide countries in difficulties into the insolvent and the illiquid; restructure the debts of the former and provide unlimited, but temporary, support for the latter; and recapitalise banks, after stress tests that allow for losses on sovereign debt, either from national treasuries or from the European financial stability facility, in accordance with the flexibility given by the decisions taken in July 2011….these ideas, albeit now necessary, deal with the symptoms of what has gone wrong, not the underlying causes. As I have long argued, at bottom this is far more a balance of payments crisis rooted in financial sector misbehaviour and cumulative divergence in competitiveness, than a fiscal crisis.

…a way must be found to deal with the immediate crisis that does not allow another panic. But that would not be a solution if it merely led to indefinite financing of fundamentally uncompetitive economies. At the same time, one-sided and unduly hasty adjustment would exacerbate the downturns in the eurozone and world economies. What is needed is financing and adjustment. Unless and until that difficult combination is achieved, we are delivering first aid not a cure.”

Even the immediate idea of using the EFSF as the saviour of all things Euro has some serious problems: “The fundamental problem of the EFSF is that everybody guarantees each other in a game of domino. Italy’s guarantees make up 18 per cent of the system. But this 18 per cent lacks credibility. Italy is hardly in a position to pay its own debt, let alone guarantee someone else’s. While France is healthier, its guarantees to Italy also lack credibility. And so do German guarantees for France. If you follow the line to the end, there is no ultimate backstop. If you double or treble the size of the EFSF without changing its underlying structure,all you do is double or treble the lack of credibility. If you really want to increase the size of the EFSF without destroying it, then you are left with two options: you have to back it through an unlimited guarantee by the ECB, the only organ in the eurozone that is in a position to give such a commitment. Or you have to change the EFSF’s legal status through the adoption of joint and several liability. This means that member states jointly agree everybody’s debt. The two options ultimately mean the same. The liabilities of the system will be shared jointly by all of its participants. If you want to annoy certain people, you could also call the latter a eurobond.”

And let’s not forget the German attitude to this idea of eurobonds…

Last night also brought the FOMC minutes: The main upshots out of that…a couple of FOMC members wanted to do more i.e. QE3 rather than Twist, and lots of discussion and a resolution to do more around communication policy. Coming only a few days after the economics Nobel prize was awarded to guys that showed how expectations of rational actors can negate or enhance macro policy actions, this is a positive step towards the Charles Evans style “rates stay at 0% until unemployment gets to 7.5%” and even nominal GDP targetting. The other interesting analysis on the statement is this look at the FOMC recognising the problem is money demand: Rising monetary targets are not a sign of inflation, they’re a sign of ongoing panic and risk aversion i.e. excess demand for money rather than assets/goods & services.

If you want to have a laugh, check out this….pension funds continue to delude themselves about potential returns going forward: There’s a reason real yields are negative and even 30y yields are around 3%.

Finally, a good one from the land of stats…it seems accounting data for US firms is slowly but surely getting more unreliable:

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SM – Go Big…

In this mixed up world we live in it should be no surprise that a holiday Monday was more volatile than an all markets open Tuesday. This despite Slovakia, the political obstacle du jour in Europe, voting no on the EFSF restructure. We’ve all been told not to worry, because apparently in Slovakia no means yes, but next week. So like good little boys and girls, we stopped worrying and instead watched Alcoa report results that can only be described as way below expectations. China over the weekend showed the Europeans how to do things, announcing a bank bailout in the form of its sovereign wealth fund buying more shares in its 4 big banks. The impact? China stocks finished the day weaker. That’s gotta be inspiring for the Europeans, even if they do manage to actually conjour up some kind of plan in the next few weeks.

Way back on Sep 21 the FOMC annouced Operation Twist. It may surprise you to learn that T10s on that day closed at 1.72%…and are now at 2.15%. Twist has been partly successful: the 10/30s curve in the US is 10bp flatter despite the market selling off since the Fed meeting. And yet the 2/10s curve in the US has gone from 152bp to 185bp. Yes, we’ve seen this pattern before, with both previous QE efforts. I’ll say it again: with the notable exception of the 30y sector, Twist will not stand in the way of a bear steepening move in Treasuries. Yours truly has a series of put spreads on TYZ1 and have covered a decent amount of my short position in EDM2…although those Eurodollars are still not really bouncing, which is a sign of further financial stress to come (or a sign the market wants to see Europe’s recap plan before dollar funding costs come under control).

Here’s today’s links to keep you busy while you’re occupying Wall St:

* Starting with Europe…5 most likely Eurozone scenarios with a % weighting: Good to note the “good” outcomes have a 25% weighting…and that’s with a generous definition of good. For an alternative take on the current Euro mess, why the periphery aren’t to blame for Europe’s woes:

* Babysitters, monetary policy and confidence crises:

* How do household balance sheets in the US compare from 2006 to today:

* The Fed could reflate the economy if it really wanted to…

* Where’s the crowding out?

* Political economy, US version: why the boom will come in 2013:

* For the so-called “99%”, where do the top 1% of US income earners actually work:

* Great moments in patting oneself on the back: the NY Fed asks if the Term Auction Facility (TAF) worked, and finds it did: “We argue that the Fed’s Term Auction Facility (TAF), introduced in December 2007, lowered the cost of borrowing of banks in the market during the recent financial crisis. In this post, we report on the effectiveness of the TAF during the early stages of the crisis. We find that the TAF was associated with a decrease in the interest rate spreads on interbank loans. In other words, the TAF worked!”

And finally, from 1928, when borrowing money, the trick is to go big:

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Merkel, Sarkosy and the Titanic

Last night’s holiday impacted session gave the risk on crowd all they needed to give everything a shove to the good….S&P rallied, bonds got hit, US$ got hit. The worry is this is all a mirage. The annoucements over the past few days can best be summarised by this snippet from a broader post talking about what Europe’s latest plan might look like: “IF ANGELA MERKEL and Nicolas Sarkozy had been captaining the Titanic when the iceberg was spotted, they would probably have issued a statement resolving to avoid it.” Markets are waking up to the realisation that the same people who haven’t had an answer for the past 3 years are going to try and come up with some magic answer in the next 3 weeks…and this time they really, really, really mean it! And even if they come up with a plan, they’ve got to get it approved and implemented…all this as we continue to watch Slovakian politics (seriously) to see if the EFSF reform from July (which feels an age away) gets through. Markets are gullible, but are we going to fall for it again? Maybe.

Straight on with the links today:

* Even the IMF is saying Oz will end up with deficits going forward (not that that’s a bad thing): Only Wayne Swan doesn’t think so now.

* Some potentially ugly news brewing in the US despite the recent change in sentiment:

* Why people talk about Great Stagnation: a look at US median income in the past few years

* Massive collection of US employment charts:

* If you want to understand why Thomas Sargent and Chris Sims won the Nobel prize for economics, try

And if you want to impress at your next dinner party, the latest physics research proves light doesn’t travel faster than light: Yes, you made a mistake no going into academia.

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SM – Broken Legs

Friday’s payrolls number wasn’t as terrible as feared, and the market almost yawned at Fitch’s downgrades of Italy and Spain. The reactions to all of this still smack of exhaustion rather than a change in trend. Merkel and Sarkozy have had a weekend chat and come out with yet another “don’t worry, we’ve got it under control” style annoucement (one summary is at All that is missing from their announcement of a plan is, well, a plan. And while markets have been flailing about for months, it’s ok because this time we’ll get a plan by Nov 3rd. It might serve to remind you that we still haven’t got the last few plans even approved (Slovakia’s having a go at voting on the EFSF tonight…) and that’s just on Greece and the ESFS. It comes down to a simple lesson: you can’t fix just one leg of a broken stool. Unless somehow Merkel in particular is going to see the light in the next three weeks, we’re not going to see what we need to see. Each of the current problems are intertwined: banks need a recap plan because of sovereign debt issues amongst the weaker Eurozone members because the ECB won’t see the difference between providing liquidity to banks and to sovereigns. Even if they get some kind of plan up, Merkel’s then gotta convince her country that bailing everyone out now is cheaper than letting things go to the sh1tter a la Lehmans. But you can’t prove a counter-factual like “if we don’t do this things will be worse” and Merkel’s not the kind of political leader who gets on with leading her people rather than following their opinion. To cue a Steve Jobs quote on market research (i.e. opinion polls): “It’s not the consumers’ job to know what they want.” Look where that got Apple. And look where listening to people is getting Germany.

So far today we’re seeing more of a “risk on” style move, but I keep pointing to the major signs of stress that I need to see turn before I’m convinced that the trend has changed. 1yr Eur/USD basis swaps haven’t budged from their distressed levels of -70 or so…and the front Eurodollar futures contracts are off 15bp plus in the past three weeks. What’s scary is the Eurodollars keep selling off no matter whether it’s a risk on or risk off move in other markets. These markets are saying that banks are still struggling for funds. That way leads to the dark side: it no longer matters if you’re illiquid or insolvenet – if you can’t fund your bank at a reasonable spread, you’re done for. That’s why I’m not so sure the Dexia bailout is a turning point in Europe’s dealing with the crisis. A bank getting bailed out for the second time in 3 years isn’t really a signal – the problem has moved on to bigger banks and bigger sovereigns. The rule of thumb with Europe remains the same: when in doubt, expect them to take the worst option possible.

On the US, saw this over the weekend from Bill Gross: “Need incentives for corporations to invest? Lower taxes? Joking? Profits as a % of GDP at 13%. All time record %. Help Main Street!”

* Europe’s institutional problem: “Europe is demonstrating that a sovereign nation without a true central bank is just an uninsured bank, liable to be tipped over by the markets.”

* Without a lender of last resort, many different equilibria interest rates are possible for distressed sovereigns:

* 4 trillion Euros doesn’t solve Europe’s problems:

* Lessons for Euro TARP from America’s experience:

* Is focusing on deleveraging a useless distraction?

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SM: If in Doubt

The plunge protection team must be happy with their work: the mysterious late rally in equities flowed into a run of headlines that something might happen which might mean chaos is averted…and that was enough to get a short squeeze going and faster than you can say “risk on” the world is a marginally brighter place. Now look in your heart of hearts: do you believe it? Do you believe the very same European policymakers and institutions that have taken months to limp towards some kind of Greek bailout will be able to cobble together a bank recapitalisation plan quickly enough to avoid trouble? There’s a good framework and summary of the idea of EuroTarp at But I come back to this: politicians that struggle to bailout a fellow Eurozone member are going to politically struggle to bail out banks. I know Greeks are on the nose in Germany, but are bankers really better? Even if these proposals were agreed (and again, Greece shows everything keeps getting renegotiated because markets keep moving faster than they do) it will take weeks and months to get set. Do banks have weeks or months? To take just one example, Soc Gen 5y CDS is around 350bp…and that’s after a risk on rally last night saw it move 20bp to the good! We also had all the confusion around whether the IMF will wade in and buy Euro bank debt (it can’t even if they wanted to) and the EU denying they’re even working on a bank recap plan. Don’t forget what I might modestly term Masnick’s law of Europe: if in doubt, assume the worst. Sure we might get a surprise from the ECB tonight with a cut in rates on top of another bout of 1y LTRO and other liquidity support, but will JCT really be prepared to wear such an about face only a few short months after he tightened? And does it matter if rates in Europe are 1.5% or 1.25%? Europe’s problems are far bigger than that. And they don’t have the political will or institutional structure to confront them. Until then, muddle through is about as good as you can expect and these risk on bounces will keep resembling dead cats rather than turns in trend.

Straight to the links today:

* The problem with 2012 is it’s a year of election and transitions in leadership in China, the US and elsewhere…which means 2011 is going to be even more volatile because central banks are not as independant as you think.

* Just how tight are Aussie rates: Very, based on this.

* End of the fake recovery:

* Using military spending to work out government spending multipliers (it turns out it’s still about 1.5x):

* How monetary policy can still be very effective during balance sheet recessions: “All in all, there’s no reason why monetary policy should be any less effective now than ever before. Yes, life is much more difficult at the zero lower bound, but the Fed can still commit to lower rates in the near future, which if credible does nearly as much as lower rates today. (Increases real estate and equity values, improving household balance sheets? Check. Makes durable goods purchases more attractive? Check. Improves corporate incentives to invest by increasing equity values and decreasing the cost of debt financing? Check.) There’s nothing special about a “balance sheet recession” that negates the value of monetary policy—indeed, if we read our vintage Bernanke, we’ll understand that monetary policy may be more important than ever.”

* Why Washington’s conventional wisdom is completely wrong on the economic situation in the US right now: “There are all sorts of problems with the conventional view, but they boil down 2 fundamental problems: 1. Grossly overestimating what the Fed has already done in terms of stimulus. 2. Grossly overestimating how hard it is to prevent excessive inflation when exiting a liquidity trap.”

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