Thursday, August 4, 2011

Look! In the sky, it's a flaming risk asset about to crash into the SS Europa: An analysis of todays market action




I'm going to take a day off of my explanation as to why the Progressives are just as wrong about the fundamentals of public finance to talk about what went on in the markets today. First, what went on:

First of all, what happened?

1.) Global equity markets fell very sharply. The US benchmark the S&P 500 fell 60 points or about 4.7%, that is a HUGE move. The stock market is now back where it was in early December of 2010. The stock market is now down about 12% from its highs for the year, it has dropped about 140 points or ten percent since July, 25th, this is a big big move.
2.) Money poured into the US Treasury market as it has since the debt deal passed. This pushed the yield on the ten year bond down to 2.42%, this is VERY low by historical standards.
3.) Money poured into, and then out of gold. On the open gold was up about $30 and then during the day dropped $40 to close lower.
4.) The Euro fell sharply against the dollar losing 1.5% of its value in a single day. This is a big move and it is also a continuation and acceleration of an ongoing trend
5.) Crude oil also fell out of bed. Brent Crude dropped 5% to $107.58 a barrel. (I prefer Brent as a measure because West Texas Intermediate largely reflects the dynamics of storage in Cushing Oklahoma but WTI was down 5% as well.)

Why did this all happen?

This is a good question first I will list the news items that have come out in the last 24 hours and then put them into context.

1.) Silvio Berlusconi gave a speech to parliament last night on the issues surrounding Italian sovereign credit. In the speech he reiterated earlier comments he has made about the soundness of Italian finance, reminded the markets that Italy has passed an austerity budget, and in any case he has a majority in parliament if he needs to do anything else. He blamed the recent financial turmoil in Italian markets on fickle markets and a lack of confidence. He did not announce any new policy measures to attempt to deal with the markets but rather pointed out that the Italian primary deficit is very low and therefore very manageable.
2.) Jean Claude Trichet held a press conference this morning at which he announced that the European Central Bank would continue its two main liquidity measures: a bond buying program, and unlimited lending against solid collateral to the end of the year. The ECB was not expected to announce whether or not it would extend these measures, originally put in place during the Greek fiasco in May of 2010, until September. He came out early with the announcement early in order to assure the markets that there would be ample liquidity for the banking system. He also made a number of hawkish comments about inflation.
3.) Spain held a bond auction. The auction went will with twice as many bids as there were bonds for sale but the rate the Spanish had to pay was 80 basis points (0.80%) higher than they had to pay at a similar auction in June, highlighting the stresses on the market for Spanish government paper.
4.) US weekly first time jobless claims came out at 400,000 a little less than expected but still a significantly high number.

First I need to put these events in context. Six weeks or so ago the EU put together a new rescue package for Greece to supplement the one agreed a year ago. The negotiations over this were tense but they were finally resolved. All seemed quite until a few Fridays ago there was a run on the stocks of the Italian banking sector, that is to say a lot of people came in and started selling short Italian banks. It was, and is, widely perceived that this is a speculative attack on Italy. It is actually not easy to borrow and short sell Italian bonds and the CDS market in them is thin. A large proportion of the assets of Italian banks are claims on the Italian government is bonds. Therefore you can get short the Italian government by shorting the banks and this is what has been going on.

There are a few interesting things about Italy. One is that it does indeed have the second highest (after Greece) debt to GDP ratio in Europe. It also has one of the most anemic economies in Europe, with almost no real growth in the ten years preceding the 2008 financial crisis and not a great record since then. On the other hand the Italian primary deficit is only about 4.6% of GDP or about a third of ours. Also Berlusconi, love him or hate him, does indeed have a parliamentary majority, unlike the Socialists in Greece. This means that, if necessary, he can with ease pass additional measures with which to tighten the deficit further. So, if you ask me, Italy is in trouble, but it has plenty of resources with which to defend itself against the speculative attack should it choose to do so. I think Berlusconi was trying to make this point last night and express confidence by not actually announcing any new measure. As you can see, the markets have their doubts.

The reason the speculative attack on Italy is so significant has less to do with the probability that it will succeed than with the consequences if it does. The European Financial Stability Fund (EFSF) that was established to rescue Greece and which has since also assisted Ireland and Portugal is probably ample for the needs of those countries, it may even be large enough to support Spain. Italy has $1.4 trillion of debt outstanding. Not only is it too large to be assisted by the EFSF, it is probably too large to be helped by anyone except the United States and even then it would be touch and go.

What this means is that if a speculative attack on Italy were to succeed in shutting Italy out of international capital markets there is no organization in the world large enough to support it and so it would be forced to restructure. If Italy were to restructure the European banking system would suffer an enormous blow. This is because not only Italian banks but all banks in Europe have substantial holdings of Italian bonds. If they were forced to recognize losses on those bonds it would eat into their capital and shrink their balance sheets along the lines of what happened in the US when the banks had to write down their investments in residential real estate. This would most likely force a major economic contraction in Europe, MAJOR. Even if this is a low probability event the consequences are so dire that many investors are preparing themselves for that possibility. They are doing this by selling risky assets (stocks generally, assets in Europe and therefore the Euro itself) and putting them into extremely safe assets.

During the budget debate a lot of these assets went into gold because there was some concern about whether or not US Treasuries were the optimal asset to be holding. Once the deal was done money has been flowing into treasuries hand over first. US treasuries have gained about 10% this week, that is also a HUGE move. This is a good thing for the US government because it lowers the cost of funding the deficit but it is not good news for the economy as a whole. This is because the spread between the two year and the ten year US Treasury yield is a good predictor of the financial performance of the financial sector. What is the business banks are in? They take in deposits and they make loans. Deposits are usually short term and loans are long term, so the difference between short term rates and long term rates is the primary driver of banking profitability. The government has been trying to help the banks recover from the housing crisis by keeping short term interest rate VERY low and leaving longer term rates relatively high. When every frightened investor in the world panics and pours their money into long term US Treasury securities like they are now the spread between the short term and long term interest rates narrows and reduces the profitability of the banking system. Lower profits in the banking system mean a longer time to recover from the 2008 recession and thus generally less credit available to the “real” economy.

The real economy in the US is also a point of major concern. Todays jobless claims number was sort of ho-hum, no reason to sell off the market 5% but there have been other problems lately. Last Friday the Q2 GDP number was released. The markets expected the economy to grow at 1.9%, not a great number but respectable. Instead the number came out at 1.3% and worse the Q1 number was revised down from 1.9% to 0.4%. These are truly terrible numbers for the real economy, in order to recover employment from the 2008 fiasco we need to be growing much faster. Those numbers were bad but the ISM manufacturing number on Monday was worse as it came out much worse than expected and showed that the manufacturing sector, the sector which has been leading the recovery as banking and real estate have been on the ropes, is just creeping along.

The uncertainty about the real economy is compounded by uncertainty as to what the policy responses will be. It seems from the data that the fiscal stimulus has been a failure. Whether you agree with Paul Krugman that it should have been larger or with me that it was doomed to failure because rational expectations of higher future taxes to fund the borrowing required deter the kinds of investments which would grow the economy, the data are pretty clear. What's more, even after the hand wringing in Washington about how to trim the deficit, the ratings agencies, and through them the markets, think the US is so deep in debt and has such crushing future obligations that it may not deserve its AAA rating. This, and the fact that there is a significant group in Congress opposed to all spending increases means that there is unlikely to be a second round of fiscal stimulus.

Then there is the question of quantitative easing. In both of his press conferences Bernanke has gone to great lengths to show that, as long as inflation expectations remain elevated, he does not have room for a third round of quantitative easing. This is bad news for the markets because they LOVE quantitative easing. QE2 took the S&P 500 up 30% between July 2010 and February this year. The Fed has said it is willing to engage in QE3 but the bar will be set high. That is, in order for them to intervene the economy needs to be slowing significantly, (which it may be but we won't know for sure for a while) and inflation expectations need to be low (which, right now, they are not.)

To this soup I would add the issues that the potential downgrades of US sovereign debt bring to the financial systems. As I have mentioned in a previous post, the global financial markets have been using the US Treasury as a proxy for the risk free rate. If in fact there are significant risks that the US defaults, every other asset in the world should be yielding more than it is given the risk it implies. As this sinks in it may well force a general shake up and reshuffling of the worlds asset allocations and it is possible that the first stage of this would be a global flight from risk which would look a lot like what we are seeing.

So here is what the markets are looking at: a potential fiasco in Europe, a slowing US economy (which will begin to shrink for certain if there is a financial crisis in Europe,) no fiscal stimulus, and very likely no monetary stimulus as well as serious questions about whether or not they are getting paid to take the risks they are taking in all financial assets. This is an environment in which many people would prefer to run home and hide under their beds which is what happened today. Add to this that the US unemployment figures come out tomorrow and there was no reason to go home long anything so there was not even a buy the dip rally at the end of the day, we closed on our lows.

What to expect going forward.

Personally I am a bit more optimistic than the markets are. I think that the odds of a successful speculative attack on Italy. I think Europe will muddle through and I think the US economy will not go into a double dip recession. Yes growth is anemic but I think a lot of what you are seeing in the numbers reflects the exogenous shocks of the Tsunami, the Arab spring oil spike, and jitters around the Eurozone. That said, speculative attacks can acquire a momentum all their own and for the time being, they seem to have the upper hand. If we get a disaster of an unemployment number tomorrow we are going to be in for another very rough day.

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