Notes From Underground

First, to Lou Reed: The market is the ultimate WALK ON THE WILD SIDE as first it dresses as a bull and changes into bear garb … the ultimate transvestite. Be at peace Lou and thanks for the years of rocking out.

As the news cycle has slowed because of the lack of immediate crisis in Washington, focus is starting to shift toward Europe and the ECB’s effort to craft a credible, EU-wide stress test. The market mocked the previous effort for being a very weak attempt at measuring real elements of credit stress within European banks. Now that the ECB has been tasked with being the conduit and trustee as a single EU bank supervisor President Draghi is going to have to be credible in the eyes of the ECB paymasters. In an interview with Bloomberg’s Francine Lacqua last week, Mario Draghi said: “The test is credible because the ultimate purpose of it is to restore or strengthen the private sector confidence in the soundness of the banks,in the quality of their balance sheets. Ultimately that’s the objective ,to have private-sector money to be put into the banking industry.”

My problem with Draghi’s stance is this: HE HAS PLEDGED TO DO WHATEVER IT TAKES TO PRESERVE THE EURO. If enough banks are failing the stress tests it will be incumbent upon the ECB to either force the banks in question to raise capital or be shuttered. If Draghi is zealous in his efforts to appear a severe taskmaster of the European financial system there is going to be a large need for additional capital to shore up an EU financial system burdened with record amounts of non-performing loans. If the banks cannot raise the needed capital to meet the ECB requirements then assets will have to be disposed of to shrink balance sheets.

Either way will create a possible need for ECB liquidity and thus possible fear of a German backlash against its role of European creditor. Thus, President Draghi is going to be forced to fudge the results for he has already claimed that job one is preserving the euro. Doing whatever it takes is equivalent to Sir Alan Greenspan providing the U.S. banking system with unlimited liquidity regardless the crisis (see: Long Term Capital Management). I do not know what view the sell-side pundits will push, but as for me I remain very skeptical about the ECB’s stress tests. There’s too much on the line for a genuine examination.

In tomorrow’s Financial Times, Dutch Finance Minister Jeroen Dijsselbloem, who is also the chairman of the European Finance Ministers, maintains that all efforts to ease the  requirements of meeting EU budgetary guidelines should be tied to a nation’s contractual agreement to meet “… twin challenges of excessive deficits and lackluster reform.” In the article “Dijsselbloem Says Budget Extensions Should Be Tied to Reform,” the authors note that many in Europe are aware of the negative feedback loop set in motion by the effort to raise taxes and cut spending with the added pressure of high unemployment. The push from Brussels is for the debt-plagued economies to become more competitive ,which is means pushing for greater downward  pressure on wages, or what economists refer to as internal devaluation.

However, downward pressure on wages in Spain, Italy, France and others will create more stress on bank balance sheets. Non-performing loans will increase because lower wages do not mean a drop in previously agreed loan terms. Dijsselbloem does not undertake to explain how the structurally uncompetitive will regain economic virtue through the creation of massive deflation, especially with an appreciating currency. If deflation takes hold in Europe with the present financial fragility of the banking system, Mario Draghi will have to walk on the wild side to escape from Frankfurt.

***Wednesday is the FOMC announcement about monetary policy. No analyst is expecting any change in current policy, but if I ran the FED I would begin tapering as a gift to Janet Yellen. If Bernanke were to begin tapering it would give Ms. Yellen a running start and would provide some wiggle room for the current vice chairman in case the economy were to begin to weaken and tapering is increased. Under those circumstances she would merely be putting back what was removed. Readers of NOTES are well aware that I do not believe that tapering by itself is the issue. The greater concern is the almost $4 TRILLION of reserves that has been created by QE. Tapering does not remove the vast pool of reserves but stops the creation of more. The issue will be what the financial system will do when the pool of reserves attains some velocity and the FED is forced into action to slow the money. Tapering is a sideshow.

Tags: Ben Bernanke, ECB, Euro, Europe, FOMC, Janet Yellen, Mario Draghi, QE, stress test, tapering

This entry was posted on October 28, 2013 at 7:55 pm and is filed under ECB, Europe, Fed. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.