First, tomorrow morning Goldman’s Lloyd Blankfein will be rolled out on CNBC to share his wisdom about the state of global markets. Maybe he will remind investors that Goldman and other banks are doing GOD’S WORK. I will write what I wrote recently: Noah and the flood were also GOD’s work so it is important for the world’s banks to signal which part of GOD’s work in which they are involved. The European bank stocks are under stress again. Deutsche Bank and many other EU money center banks continue to make new lows every day. What are investors fleeing from? Probably the huge amount of NON-PERFORMING LOANS that exist on bank balance sheet and will have to be met with NEW CAPITAL to meet the more stringent regulatory requirements from the European oversight authority, as well as increased capital requirements under Basel III. There is a great effort to initiate a FDIC-type of deposit insurance program for all of Europe–a single agency–but the Germans will not allow their CREDIT CARD TO BE USED UNTIL THE PRESENT BALANCE SHEETS OF ALL THE FINANCIALLY STRESSED INSTITUTIONS ARE PURGED OF INSOLVENT, ZOMBIE TYPE LOANS. The lack of any banking guarantee is creating an underlying tension throughout the European financial system and without a robust corporate bond market there is nothing to disintermediate the financial power of the banks. The ECB is vacuuming up all the high quality collateral so finding adequate borrowing instruments to facilitate lending is adding to the drag on the EU economy.
Things are rotten in Europe and getting worse. The ECB will have to cut rates again in March just to ensure that there will be enough sovereign debt to purchase under the rules of engagement Draghi created for the QE program. So, if this is the situation why does the EURO rally? In my opinion the euro’s recent strength is a result of the carry trade unwinding. Many investors borrowed in euros because of the interest rate differential to the DOLLAR and hoped that the FED’s policy to RAISE RATES FOUR TIMES WOULD DEPRECIATE THE EURO. Well, as Stanley Fischer moved to a new ballpark yesterday, the short euro positions are exiting. The fundamentals in Europe are atrocious but global macro is first and foremost about FLOWS and the FED‘s uncertainty is unnerving some investors. The weakness in the DOLLAR is causing a short-term adverse feedback loop in which a rise in the euro creates even more selling in the European equity markets leading to more selling in U.S. stocks. The U.S. dollar has recently been a low correlative variable for the American equity markets. This would probably change if the DOLLAR had a sizable correction but for now it is not a driving force for valuations.
The 2/10 U.S. yield curve has closed below the 115 positive sloped level for two straight session. This was the level of support that the curve had held for the past 40 months but with Japanese bonds trading at 0.08% (8 basis points) and the German bund trading at 0.30% (30 basis points), the world is in search of high-quality sovereign debt so demand increases for the U.S. 10-year note and all the other U.S. Treasury paper. It is a world in search of minuscule amounts of safe returns–1.80% is in demand–pushing the 2/10 flatter. Global demand for safety is disrupting the plans of the central banks. Don’t put the money into the banking system but purchase sovereign debt as a worthwhile alternative in an uncertain world. The more negative the rates go the more afraid investors seem to get.
Today, the BOJ announced it was cancelling tomorrow’s JGB auction for retail and municipal buyers for fear of negative rates. In Japan, most of the bonds are held by domestic buyers, far higher than any developed economy. A political backlash may emerge as Japanese investors are financially repressed by negative interest rates with inflation more than 0.5% percent. It was a different situation when JGB buyers were getting 60 BASIS POINTS and Japan was experiencing deflation or negative pricing power. If prices in Japan were dropping by 1 percent per annum and rates were 0.60%, the EFFECTIVE REAL YIELD WOULD BE 1.6%. But now the REAL YIELD EVEN ON 10-YEAR NOTES IS NEGATIVE (AS WELL AS NOMINAL). These may cause political problems for the BOJ, especially ABENOMICS.