Notes From Underground: The Mother of All Debt Crises

Everything in global financial crisis emanates from too much debt being unable to be serviced. The current situation in Argentina is that the state and private sector borrowers won’t be able to pay the INTEREST on its dollar-based loans as the PESO weakens. It takes more domestic currency to purchase the needed dollars to pay creditors, resulting in a NEGATIVE FEEDBACK LOOP that brings the economy to a crawl as all the economic actors have to find ways to pay the interest costs or go bankrupt. The Argentinian government won’t go bankrupt. But it will force a debt restructuring if its borrowing costs move higher (yet another burden for a debt-plagued economy).

Argentina is far from the only global problem as its debt load is far too small compared to many other regions of the world–Turkey, China, Illinois–including the mother of all, the European Central Bank. The ECB has accomplished building a massive balance sheet in which it has accumulated the sovereign debt of European nations dependent on the ECB maintaining a policy of ultra-low interest rates to insure against rising interest rates.

Italy runs a DEBT-TO-GDP ratio of 132% but is able to borrow 10-year debt at 1.87%, much lower than the U.S. rate of 2.97%. In measuring the short-term duration of 2-year notes the situation is even more ABSURD. Italian yields are -0.27% while the U.S. 2-year is a positive 2.54%, which results in a differential of 2.81 percentage points. Even with the ridiculous bank-manipulated rates the Italian government has not been able to shrink its debt-to-GDP ratio as its economy grows at a very tepid rate … reductio AD ABSURDUM.

Ambrose Evans-Pritchard’s May 10 column in the London Telegraph–titled “EU Officials Braced For ‘Nightmare Scenario’ As Anti-Brussels Radicals Prepare to Govern Italy”–further expounded on the Italian situation. Evans-Pritchard cited the Lega’s chief  economist Claudio Borghi as maintaining that Italy will do what it needs to in order to stimulate economic growth.“Mr. Borghi said his party would refuse to rubber stamp Brexit policies imposed by Berlin.” As this blog has discussed for many years, Italy has the leverage over Brussels because the Draghi-led ECB has been the largest buyer of Italian debt in an effort to send euro-area interest rates to levels that are beyond any meaningful risk valuation.

As Evans-Pritchard noted: “It is a hazardous moment for Italy to start awakening the global bond vigilantes. The ECB is to wind down its debt purchase programme by the end of the year, depriving the Italian treasury of a backstop buyer for its debt. The country has a refinance debt equal to 17pc of GDP this year, one of the highest ratios in the world. A study by HSBC concluded that the ECB has mopped up half the gross supply of Italian debt during the QE phase and shaved at least 100 basis points off Rome’s borrowing costs,flattering the fiscal profile.”

Even more important: “The worry is that Italy has continued to suffer chronic capital flight even during the economic recovery. The proceeds from QE have been recycled out of the country into accounts in Germany and Luxembourg. The Bank of Italy owes 426 Billion euros to its ECB peers through the internal Target 2 payment system. This was supposed to self-correct. It has not done so.”

The Italian banking system is so fragile that Italians hold euros in other European banks in order to avoid any type of bail-in program, which would lead to losses of bank deposits. The large Target2 imbalances provides the Italians with great leverage in any negotiations over the fiscal policies of the Lega and Five Star. Remember, Italy is not Greece because any concern about Italian solvency will send the international financial system into contagious paroxysms. The Italian sovereign bond market is the world’s third largest.

There was a Financial Times piece by Claire Jones titled, “ECB Head Draghi Back France’s Call to Complete Banking Union,” which fanned the flames of a narrative devoid of reality. The article picks up on Draghi’s April press conference when the ECB president proclaimed that he would be ready and willing to offer advice to the EC concerning the harmonization of European Union fiscal policy and of course a unified banking union. French President Macron has been pushing for a “stronger eurozone, more deeply integrated, with its own budget allowing for investment and convergence.” The problem for Europe is that the actions of ECB President Draghi over the past five years have raced ahead of the political support of many European nations.

In an effort to do “whatever it takes” to preserve the euro currency, the ECB has taken on the credit risk of the entire European system. But as the giant of German economics Otmar Issing has warned, the ECB’s actions have been a project of the Brussels elite, yet the German electorate was never polled as to how far they wished to go in BACKSTOPPING the EU system: “no taxation without representation.” It is the good Bavarian Burghers who will be asked to the shoulder the financial responsibility of the ECB’S balance sheet. The political winds are already blowing against the support for a harmonized banking system as the Dutch, Austrians, Danes and Finns are reticent to take on the Italian banking risks. Non-performing loans are still floating around the system because otherwise the Italian banking sector would be rendered insolvent.

If the Germans are not willing to bail out the EU financial system it will not happen. The ECB policy has created a zombie banking system dependent on the continued support of the central bank. Villeroy of France and a member of the ECB board reported Monday that the ECB would be normalizing monetary policy sooner rather than later.

More B.S. from the policymakers in Europe. The current status of the Italian political situation will be the major determinant of ECB outcomes. The Italians are aware that the huge amount of Italian public and private debt provides the leverage needed by Rome to put into place some of the campaign promises of Five Star and Lega. As discussed in the Evans-Pritchard piece the operative question is: Will the borrowers or creditors have the greatest impact on policy?

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16 Responses to “Notes From Underground: The Mother of All Debt Crises”

  1. asherz Says:

    Yra- You hit the key point. DEBT.
    Germany makes one think of the mythological Atlas supporting the globe (in this case the weak links in the EU.)

    One break in the chain link breaks the chain. Rome is one of the major weak links. France is pushing a banking union because their own weaknesses and demographic problems need a big umbrella. QT by Draghi? Don’t bet on it or see a Eurozone Bond floated.

    The US is not immune in years ahead to being immune from the debt bomb. 12 zero budget deficits on top of a 21 billion dollar national debt is worrisome.

    More debt is not the solution to a debt bomb.

  2. Mike Temple Says:

    Thoughtful piece.
    I am reminded of the adage, “If you don’t borrow too much but you run into default, it’s your problem. Borrow too much, however, and your default becomes the banker’s problem and now you are partners.”

    By all “logic”, Brussels and Draghi cannot do to Italy what they did to Greece. The Target 2 imbalances are truly Germany’s problem.

    Does Germany have the nerve NOT to accommodate Italy and cause absolute chaos in Europe? I don’t see it. Draghi has foisted a de facto “union” onto Europe, and now here comes Macron to try to codify it de Jure.

    If Germany “blinks”, should not the Euro soar?

    In a financial world that seems to be growing ever more spasmodic and chaotic (just look at EM), Capital May soon run scared, as it did during the last Euro crisis in 2011. If capital flees to King Dollar, that further creates funding stresses globally.

    Seems to me to be time to convert “risk on” attitudes towards that ASCENDANT ASSET of yours….US cash which now sports a suddenly SAfE harbor with yield.

    Yet, hot flows into USD May boomerang, too, as US will suffer more de facto tightening.

    I foresee “Risk Off” coming to a theatre near you this summer.

    Spasmodic moves in Argentina and Malaysia….Even Mother Earth is convulsing with Hawaiian volcanoes and other “Ring of Fire” eruptions.

    Does President Trump and/or Fed Head Powell strike any of us as financial saviors if a global financial conflagration breaks out?

    Cash looks might mighty attractive. And I think all this chaos could produce a simultaneous “fear” trade where both USD and gold rise together.

    Meanwhile…..Go Cubs

    • yraharris Says:

      Mike—I think you should put this blog post to a billy joel song..But I agree with you –if the Germans capitulate to the designs of President macron and agree to be the ultimate creditor for the ECB Euro will get a bid as there will be a ready alternative to the Dollar –but we didn’t start this fire.The end result then will be the eurobond that Draghi has surreptitiously built in an effort to trap the Germans—as you say if germany blinks we will have to reconsider many different variables

  3. Brian Auger Says:

    Thank You Yra for your insightful and interesting posts. I have not written to you before, but I have been a fan of your commentary for many years.

    Relative to this current one, can you give me any suggestions about how to short Italian debt? I mean via ETFs or other related markets. I don’t generally do futures or shorting .. too sophisticated for me. But I like your thesis and would like to take part in the future return to greater sanity that reality will impose.

    Thanks! Brian Auger A Canadian in The Netherlands

    On Tue, May 15, 2018 at 04:11 Notes From Underground wrote:

    > Yra posted: “Everything in global financial crisis emanates from too much > debt being unable to be serviced. The current situation in Argentina is > that the state and private sector borrowers won’t be able to pay the > INTEREST on its dollar-based loans as the PESO weaken” >

  4. Chicken Says:

    So I’m wondering if the euro fails support here and breaks down. Personally, I was taken by surprise by strength in past months but Yra, you warned us.

  5. Mike Temple Says:

    Nice observation about the Billy Joel lyrics.

    UST 10 year at 3.05%. Last time we saw such a yield was mid 2011. S&P was just 1100ish. Am not predicting a crash. But if/when corporate share buybacks slow after the one time tax repatriation, stocks don’t look so great compared to 3%+ yields and 2%+ cash.

    Nobody ever wants a war (except perhaps Mr Bolton). Yet, Powell seems determined to continue to raise rates while EM markets begin to rumble and while QT, never before seeen, works its insidiousness.

    Strange days, indeed. Who in Brussels is going to unbraid Italy?

  6. Richard H Papp Says:

    The London gold second fix broke an 18 month ascending channel with a number below $1300 on my 4 X 12 point and figure chart. Looking @ the last several years there seems to be lots of support with a 12 handle.
    But a trendline connecting the lows of 12/15 & 12/16 currently comes in @ 1180-1200 area. Unless 1300 is quickly recaptured ……………………?

    • yraharris Says:

      Richard–very good analysis and the rise in short term real yields is having a negative impact on Gold as has been discuused in this blog for a few years—but let’s see if it can be sustained—it is a concept of all fiat currencies but right now the Dollar aspect is driving gold lower

  7. Michael A Temple Says:

    1300 will be quickly recovered, says I

  8. GreenAB Says:

    “The anti-establishment 5-Star Movement and far-right League plan to ask the European Central Bank to forgive 250 billion euros ($296 billion) of Italian debt, according to a draft of a coalition programme the parties are working on.”

  9. Stefan Jovanovich Says:

    An anniversary worth noting:

    1972: Economist Milton Friedman rings the opening bell at the Chicago Mercantile Exchange to inaugurate the worlds first day of trading in foreign-currency futures. Friedman inspired the Merc to create the new market after several banks refused to fill Friedmans order to short-sell $300,000 worth of British pounds sterling on the U.K. governments indication that its currency was overvalued.

    Susan Abbott Gidel, 100 Years of Futures Trading: From Domestic Agricultural to World Financial, Futures Industry, December 1999/January 2000, p. 16.

    • yraharris Says:

      Stefan—thanks for the reminder and I have heard that story about uncle Miltie many times .It was an important period for me as I was coming out of graduate school in 1976 and has done substantial research on Multinationals and the flow of capital—great book was Sovereignty at Bay by Raymond Vernon–still highly relevant as was Bob Gilpin’s Transnational Corporations.

  10. Michael A Temple Says:

    Interesting Article

    Juncker says that EU will mandate that European companies disregard the US and continue to do business/trade with Iran.

    So, here is my question….If EU/Brussels is about to band together as one in opposition to Trump, and if Merkel is on record as saying that Europe can no longer rely on US to be its partner/saviour, then why would Germany stand as one on this grand political statement outlined above by Juncker, but simultaneously undermine the Euro by refusing to federalize the Eurozone financially?

    Germany has already “lost” by virtue of its net credit of 460ish BN in Target 2 reserves….Those reserves are most assuredly lost if the Euro gets smashed to smithereens….Will Germany really be much better off in a world where EUR gets destroyed, or will they be forced to acknowledge the de facto federalization that Draghi has instituted the past 5+ years.

    As you pointed out, Italy ain’t no Greece…..Can Brussels really do to Italy what they did to poor Greece?

    Again, as I watch this US/EU dispute over Iran harden into some real policy differences, is Brussels’ next step to destroy the EUR, after standing up to the Big Bad Trump Bully?

    Somehow, I just don’t see it. Certainly not much of an economic analysis….But the political winds seem to suggest strongly some sense of European unity against the now vilified US position against Iran.

    • yraharris Says:

      Michael–your analysis is correct and as I have joked ,Draghi has created a Bronx Tales scenario in which he has captured the germans by building up the ECB balance sheet which has rendered Germany its creditor.The Target 2 balances are the cherry on the top and the Italians are very aware that if the germans talk tough they will threaten to bring the international financial system to its knees.Your post will provide for a full blog but much of this has been discussed in NOTES for several years–but get ready for the French and especially Draghi to be the subjects of German anger as they realize who the sucker at the table has been.This would have been politically okay if the Bavarian Burghers had actually been asked to support their own financial repression

  11. Arthur Says:

    Liquidity moves markets – Stanley Druckenmiller

  12. David Richards (@djwrichards) Says:

    Look no further than the US corporate & high yield bond market to find an historical implosion waiting in the wings. Consider:

    1) An unprecedented amount of US corp debt has been issued at historically low rates that folks will want to sell if rates move up;

    2) No liquidity as tighter regulations has unintended consequences of removing banks from making markets in HY & corp debt;

    3) Large bond ETF’s have created a massive mismatch between promised and available liquidity for investors, ie, impossible for ETF holders to sell except in tiny amounts.

    Bottom line: Structurally a perfect setup for a CRASH in US debt markets, as bad or worse than the US toxic debt setup ten yrs ago.

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