New Bull or Bigger Ro,Ro
by Doug Noland
February 08, 2013
CNBC’s Andrew Ross-Sorkin (February 7, 2013): “Are you worried about Europe, still?”
Former Secretary of the Treasury and Goldman Sachs co-chairman Robert Rubin: “I think that Europe is very different than most people think it is. I think there’s a complacency about Europe that is probably a product largely of… the announcements Mario Draghi made. And I think he’s an outstanding leader and, in fairness, he’s a very good friend. But that has nothing to do with my evaluation.
He made an announcement on a Thursday that he was going to do what was needed. And the markets reacted very positively. He subsequently, very wisely, said that the ECB was only going to act if conditionality was met, so that the politicians would do what they need to do. I think there’s been a very substantial complacency in Europe and I think the risks are probably considerably higher than people think. And I'll just add one more point: a lot of the Europeans will say a lot’s been accomplished over the past year. What I think is that European leaders have been behind the curve from the very beginning. And if you look at the facts now, in the troubled countries, the banking systems, nobody knows what the numbers are. Growth is still negative and therefore the output gaps are greater and the debt-to-GDP ratios are greater. So I think Europe is probably far more troubled.”
Ross-Sorkin: “More tail risk? I was just in Davos. They said tail risk is off the table. Mario Draghi came out and said ‘it’s over; don’t worry about it.’”
Rubin: “There is a complacency -- I think Mario Draghi, who I think is outstanding, has a role to play. But I was not at Davos. But people tell me that there was this sort of attitude you just described, and I've heard people who were there describe it as complacency. I would certainly describe it as complacency. And I think it’s a function of a misreading – a misreading of what the ECB’s action could actually mean.”
This past July the euro was under major selling pressure and about to break through the key 1.20 level versus the dollar. Spanish 10-yr yields surged above 7.5% as Italian yields surpassed 6.5%. The marketplace was questioning the creditworthiness of literally Trillions of European debt. Accelerating capital flight out of Europe’s troubled “periphery” – and continental Europe more generally – had become a major market worry. The stability of the entire European banking system hung in the balance. The dollar was rallying strongly, with a “hot money” run from susceptible “developing” economies also a mounting concern. And with the European economy faltering rapidly, the Chinese Bubble Economy under pressure and the U.S. economic recovery downshifting, global markets and economies were in a poor state to manage through a severe European crisis.
Dr. Draghi responded with his Outright-Monetary Transactions (OMT), a strategy to backstop faltering debt markets with potentially unlimited European Central Bank (ECB) purchases. This was followed quickly by Bernanke’s dollar-weakening plan for open-ended quantitative easing – which was generally supported by myriad easing measures from central bankers around the world.
It will be interesting to see how history judges Draghi, Bernanke and global monetary management during this recent period. Increasingly desperate measures have thus far held a return to global crisis conditions at bay. Does this ensure the eruption of a greater crisis later? We do know that Draghi’s OMT market backstop dramatically altered market perceptions. He almost singlehandedly transformed Trillions of some of the most appealing securities for shorting into the most enticing for leveraging on the long side. Draghi, Bernanke and friends certainly incited a major global unwind of bearish positions and risk hedges. And with the help of $85bn monthly QE from the Fed and talk of open-ended QE from the Bank of Japan, this “short squeeze” morphed into a major – perhaps historic - period of “risk on” speculation.
Mr. Rubin’s comments resonate, especially this week. The degree of complacency with respect to Europe is, on the one hand, astounding. On the other, it is perfectly understandable. News, analysis and “investor” perceptions always follow market direction. And as George Soros explained years ago, market perceptions can create their own reality. It all boils down to a major consequence of these heavy-handed global government risk market intrusions/interventions: short squeezes and “risk on” speculative dynamics take on lives of their own – leading to market prices and ebullience detaching from troubling fundamental underpinnings.
Again from Rubin: “I think it’s a function of a misreading – a misreading of what the ECB’s action could actually mean.”
Well, Dr. Draghi’s market backstop pronouncement profoundly altered global markets. And while the Draghi Plan has had a powerful impact on perceptions, from day one this market backstop has rested on rather flimsy foundations. First of all, the Bundesbank – by far the most powerful central bank in Europe - remains adamantly opposed to open-ended bond purchases. So, how big could one expect the OMT bazooka to become without the Germans – not to mention other euro-zone central banks and Parliaments – on board? Draghi had to really bend/break the rules to claim that potentially open-ended debt purchases were within the ECB’s mandate – as opposed to state financing and bailouts which are specifically forbidden.
In order to garner the necessary support from other ECB members, Draghi made debt support conditional upon a country’s politicians agreeing to a specific structural reform program (through the ESM bailout mechanism). In the midst of intense crisis conditions, this conditionality seemed acceptable to (most) ECB governors and euro-zone politicians alike. Now, with markets exuberant and financial conditions much loosened, politicians have returned to being politicians and central bankers have been left to pray that reform programs don’t completely collapse.
The hope, of course, is that the OMT never sees the light of day. The hope is that liquid debt markets (and lower market yields) work their magic on real economies. And so long as the hedge funds and others stay enamored with European debt (and the euro), the ECB market backstop can indeed remain mothballed. But along the way - if “risk on” somehow again succumbs to “risk off” - and the leveraged speculators turn nervous, this whole issue of “conditionality” becomes a market concern. If hopes are dashed and easier Credit and inflated securities prices fail to jolt economic recovery – then the region will be facing only more acute problems. These would include larger quantities of suspect debt, additional financial leverage, greater fragilities and, presumably, more intense public frustration and political instability.
The past six months have not been all that kind to the reform process. The markets have shined, though real economies throughout Europe have continued to dull. Seemingly unbeknownst to market participants, European recessions and public angst have only deepened. Weak political leaders have weakened.
The notion of ECB “conditionality” rests upon political stability. Yet, two of the region’s bigger potential problem-children – Spain and Italy – appear to be facing acute political uncertainties. Italian elections are now less than three weeks away. A savvy old campaigner and a resonating populist (anti-reform) message have propelled a surprising rise in the polls for Silvio Berlusconi’s People of Liberty party. Meanwhile, the former professor, now Caretaker Prime Minister, Mario Monti really struggles on the campaign trail. There is increasing talk of “inconclusive” results, a “hung parliament,” and potentially the need for a second election, as the leading Democratic Party (and its leader Pier Luigi Bersani) sees its lead in the polls almost disappear. The likely outcome will be a fragile coalition government and limited power (not to mention desire) to move forward with difficult reform programs.
The political backdrop in Spain appears even more tenuous.
February 6 – Financial Times (David Gardner): “The avalanche of slush fund allegations threatening to engulf the ruling Popular party of Mariano Rajoy is only the latest in a long line of illegal party financing cases in Spain, after the restoration of democracy in 1977 brought with it the expensive inconvenience of regular elections. In the mid-1990s, there was the Filesa scam whereby the then-ruling Socialists collected large corporate donations for fictitious consultancy work not carried out by dummy firms. The scandal helped bring down the government of Felipe González… The current, so-called Bárcenas case, which centres on the purported secret accounts kept by former PP treasurer Luis Bárcenas that detail covert donations and cash payments allegedly made to senior party figures including Mr Rajoy, is in the same league.”
Prime Minister Rajoy has denied receiving illicit funds, although in some cases payments on the purported handwritten ledger (published by El Pais) have been confirmed by other recipients. The opposition party has called for Rajoy’s resignation. This scandal doesn’t look good, although some have suggested it might remain in the courts for awhile. Yet it further weakens public trust, while emboldening separatist movements.
The Financial Times’ David Gardner notes a key risk: “…A [Popular party] back in power for barely a year risks implosion, but the Socialists, demoralised and divided regionally as well as ideologically, are in retreat. If elections were to take place now, Spain could face Greek-style political fragmentation, with the two main parties reduced to something like the diminished size of Greece’s conservative New Democracy and former prime minister George Papandreou’s Pasok (which, like the PP, also had a recently won absolute majority). Two decades ago Spaniards were enamoured of Europe. Now, amid the compound devastation wrought by the fiscal, banking and euro crises, the EU is ‘like a wicked stepmother’, one Spanish analyst says.”
Speculative markets love “bi-polar” backdrops – that is, as long as the bad pole (“risk off”) ensures an aggressive policy response, short-squeeze and abrupt lurch toward the good pole (“risk on”). And, over the years, everything has just gotten a lot bigger – and, accordingly, only more bi-polar.
Remember the “asymmetrical” policy response issue from the Greenspan years? Well, these days of systemic structurally maladjusted economies and financial systems, global “risk off” provokes just the most incredible policy measures. In contrast, what kind of provoking do we see with a major bout of global “risk on” market speculation? Well, essentially no response whatsoever. To be sure, the Fed’s $85bn monthly “money printing” operation is exempt. Extreme global monetary looseness? Right. Exempt.
The inevitable upshot to this unwieldy “risk on, risk off” and attendant New Age Policy Asymmetry is unanchored global liquidity and general currency market instability. The Draghi and Bernanke Plans incited re-risking, re-leveraging and an absolute global market liquidity bonanza. Many now talk openly of “currency wars” – recalling the destabilizing “beggar thy neighbor” Credit/currency devaluations from the Depression era. Watching their moribund economies, European leaders are getting antsy. And the elevated euro (weak dollar and yen) was the target of strong words this past week from French President Hollande: “We can’t let the euro fluctuate according to the mood of the market. We have to act at the international level to assert our interests… We have to determine for the medium term an exchange-rate level that appears most realistic, that is most in line with the state of our real economies.”
The euro weakened 2.0% this week. Even Draghi seemed to imply that the ECB would now closely monitor the consequences of a strong euro. Recent euro sentiment had turned quite bullish, in the face of major economic and political uncertainties. If this week’s reversal points to a shift in sentiment against the euro, then we’ll have to closely monitor how this translates throughout European securities markets. European equities have rather quickly given up most of what were strong January gains. In particular, European financial stocks were under heavy selling pressure this week. Debt markets are also indicating heightened vulnerability. And, while we’re on the subject, “developing” markets didn’t trade all that impressively this week either.
As noted by Robert Rubin, “There’s been a very substantial complacency in Europe and I think the risks are probably considerably higher than people think.” I’ll suggest complacency and unappreciated risks are a global product of worldwide monetary disorder. And with all the talk of new secular bull markets, I’ll suggest that the backdrop might actually be more conducive to just A Bigger “Ro,Ro” (risk on, risk off) Dynamic. If so, it will be key to monitor for potential subtle shifts away from risk-taking and leveraged speculation. A weak euro, recovering yen and stronger dollar might be expected to engender a somewhat more cautious approach to risk-taking. Yields in Spain and Italy should be monitored closely, along with Credit spreads/risk premiums more generally. Almost across the board, these indicators this week pointed to a somewhat less robust “risk on” market backdrop.
I’ll conclude with a Thursday exchange from CNBC, which brought back memories of the first time I heard that Dr. Bernanke was being considered to replace Alan Greenspan (when I said to myself, “You’ve got to be kidding.”).
NBC’s Steve Liesman: “I want to bring you some exclusive parts of the interview which we taped after the live portion ended really from the man who has done more than anybody else to promote this idea of the Federal Reserve using economic targets, a real revolution in central banking. Evans sees evidence already that QE, this unlimited QE, this QE linked to economic targets is working. He sees it is in auto loans. He sees it in a revival in the housing sector. But, most importantly, he sees it happening in the minds of investors.”
Federal Reserve Bank of Chicago President Charles Evans: “The investment climate seems to be one where people are increasingly understanding that very low interest rates on super safe assets are going to be around for a while. And if they’re worried by that they need to take on more risk - and taking on that more risk will help get the economy growing.”
Liesman: “Guys, this idea of economic targets going global, you talked about Mark Carney heading over to the Bank of England. There’re some discussions as to whether or not he adopts a nominal GDP target. Japan’s focusing more on economic targets. So if this works, guys, I have to start thinking a crazy idea: why aren’t we thinking about Charlie Evans as a possible replacement for Ben Bernanke in 2014?”
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