It has been refreshing to sit and watch the world spin without the pressure to react to the daily dose of instability. Europe is devolving into the mess that I have been blogging about for almost five years. Two weeks ago I appeared on Rick Santelli’s show and made the comment that anybody who puts money on deposit in a European bank is a MORON. Why would you place money in an institution that pays ZERO when you have great risk of losing a large part of your savings? Capitalism is all about reward/risk and taking great risk for minimal reward is the true measure of stupidity. THE PROBLEM FOR EUROPE IS ITS BANKING SYSTEM. The high level of unemployment has led to high levels of non-performing loans, which has clogged the credit creating system of European banks. In Europe the credit system is heavily dependent on banks rather than corporate bond markets. BANKS ARE NOT LENDING BECAUSE SOVEREIGN BONDS ARE SAFER, especially with the Asset Quality Review (AQR) results that are being released in mid-October.
The AQR is Europe’s second attempt to establish a credible stress test for the balance sheets of European banks. In order to dress up their balance sheets ,European lenders are loading up on European sovereign debt because SOVEREIGN DEBT HAS A RISK WEIGHTING OF ZERO under the terms of Basel III. So to borrow money from the ECB at zero and buy a basket of Spanish, Portuguese, Italian and Greek debt, and earn the difference without increasing your reserve … well, that’s truly free money. THIS IS WHY EUROPEAN BONDS ARE AT RECORD LOWS. Mario promised he would protect the euro system and its sovereigns resulting in the markets having no FEAR of nation-state solvency. The ECB and Draghi have created a positive feedback loop for European bonds as banks take LTRO money and continue their feast on sovereign debt. But I BELIEVE depositors have started moving money out of European financial institutions and into U.S. assets from Treasuries to S&Ps for the European banking system is not paying for the potential risk.
Remember, Europe does not have an FDIC system in which a central authority backstops deposits. The TEMPLATE for Europe by its own admission was the Cyprus banking crisis in which depositors became creditors and were forced to surrender deposits to aid the financial system in the bailouts of banks. Previously, when ITALIAN, Spanish, Portuguese and other bond yields were much higher than U.S. Treasury yields. Foreign money was willing to buy the European sovereign bonds, but now that European bond yields have been compressed through bank purchases global investors are now heading back to the U.S. dollar assets.
The impact from dollar purchases has been a major reason for the continued flattening of the yield curve, especially the 5/30, which has reached at seven-year low at 148 basis points. (This has been a BULL FLATTENER due to major inflows into U.S. assets.) Yes, I know that many think the flattening is due to the new-found “hawkishness “of Chair Yellen in her Jackson Hole speech. In reading that speech several times I still don’t see the hawk in Janet Yellen. In fact, I believe that two sentences made the speech dovish: “I expect, however, that our understanding of labor market developments and their potential implications for inflation will remain far from perfect. As a consequence, monetary policy ultimately must be conducted in a PRAGMATIC MANNER that relies not on any particular indicator or model, but instead reflects an ongoing assessment of a wide range of information in the context of our ever-evolving understanding of the economy.”
I am a fan of pragmatism but when a serial modeler such as Yellen casts aside her favorite tools she is searching for rationale so as to keep rates as low as possible for as long as possible. This results in what Chair Yellen proclaimed to be the Fed’s Labor Market Conditions Index, composed of 19 labor indicators. Prior to Yellen’s Jackson Hole speech, Minnesota Fed President Kocherlakota delivered a speech on August 15 in which he hinted at the coming changes in the Fed’s reading of unemployment data. Kocherlakota noted that people between 25 to 54 with jobs was disturbingly low–76.7 percent vs 80.3 percent in January 2007. Also noted by the Minnesota President was the high number of part-time workers desiring to have full-time jobs–an indicator of SLACK in the labor markets. The Fed will continually move the goalposts to insure against rising rates prematurely. The FED is a continuous work in progress and again it is not ROCKET SCIENCE, even as some continue to portray it as such.
***ECB President Mario Draghi paid a visit to Jackson Hole and delivered what the uninformed deemed an important speech. Nonsense! Draghi merely reiterated what we have discussed ad nauseam. President Draghi admitted that the ECB had done much to alleviate the pain of the financial crisis and it was time for fiscal policy to become a stimulant rather than a drag on the European economy. It was a direct attack upon Germany and its continued emphasis on budget consolidation as the key to correcting the economic ills plaguing so many of the European nations. Prior to Draghi’s Jackson Hole speech Chancellor Merkel delivered a speech to prominent economists–Nobel Prize Winners–and continued to push for the restructuring of national fiscal policy to improve growth prospects for European economies. The German push for Growth Through Austerity … this is what Draghi is battling against. There is no doubt that Draghi is pushing for loose fiscal policy as a major element in fostering French and Italian growth. Don’t think that the French are not maneuvering against continued efforts by Germany to instill budgetary discipline in the economic stagnation.