First, from Dennis Gartman:
The dollar and the Japanese yen reign absolutely supreme as the world continues the rush to exit from the EUR in whatever form it now holds them. Stock markets around the world are imploding it seems, and as they do, "risk" in any form is being unwound, forcing the Yen/EUR cross to move several "Big Figures" in the shortest span of time we have seen in our years of trading. Only in the "Russian/Emerging Markets Panic" in August of several years ago have we seen movements such as these. We stand in awe and we stand in fear.
Thus to begin, we say here this morning, mincing no words whatsoever, we are more frightened now for the future of the global capital markets than we have been at any time in our thirty+ years of watching, commenting upon and taking part in them. We are fearful... and we mean this fully... that we have passed the tipping point; that things are now spinning out of control; that forces have been unleashed that cannot be stopped without some truly massive, truly strong-handed, governmental action including the closure of markets and limits upon bank withdrawals, et al. These are troubling times, and our fear is palpable and growing. Worse, these concerns are giving rise to the likelihood that the Left shall be in ascension, and that manifestly left-of-centre, interventionist government lies ahead here in the US and in Europe. Higher, rather than lower taxes will be the end result. Greater... indeed very much greater... intervention in the capital markets lies ahead. Trade and act accordingly.
To put things into proper perspective, it is reasonable to see the Yen/EUR cross move within a 1 Yen range, high to low in any twenty four hour period of time. Beyond that, the situation becomes uncommon. 1.5 Yen movements, although not rare, are unusual, and 2 yen movements in the cross as "Black Swans" indeed. Now, it seems the world is filled with black swans, looking about for the few white ones that remain, for the Yen/EUR cross, having closed near 144.50:1 on Friday afternoon... which was already rather weak for the cross was trading 156 only a bit more than a week ago...is this morning trading 140.50!
We have long said that this cross relationship is the barometer of the relative health of the global capital markets, for over the course of the past several years as risk was embraced Mr. and Mrs. Watanabe would sell their Yen holdings and "swap" them for investments abroad that might return them more money. At the same time, foreign non-Japanese investors were very willing to borrow in Yen terms, take that low cost capital outside of Japan and invest elsewhere. This was the "Carry Trade" and it was one of the driving forced in the global capital market. Hedge funds around the world employed the "carry," borrowing cheap Yen and investing into anything, anywhere around the world where the returns were larger. Once confidence began to ebb, however, and once the losses on the carry trade itself began to wane, the pressure upon those exposed grew.
Now, not only are those who borrowed Yen and bought EURs, or Aussie dollars, or Russian Rubles, or gold, or equities anywhere around the world, or debt securities of almost any kind, finding that they are losing money on the "cross" itself, they are losing more and vast sums on the investments they made. It is horror story writ large and getting larger.
Is there any fundamental investment reason to be bullish of the Japanese Yen? No there is not. The demographics of Japan are horrid as her population ages and begins to actually decline. We have written often of this demographic time-bomb that is exploding consistently over time in Japan. The country's population is imploding and it continues to do so despite government policies aimed at changing that trend. However, once demographics as consequential as what is happening to Japan become entrenched, time... and very, very long periods of time,... decades certainly; centuries perhaps... are needed to reverse the course.
Thus, the only thing driving Yen higher is the panic liquidation of the "carry trade." This unwinding has been going on for several months, having begun in earnest in July when the cross touched 170:1 ever-so-briefly. It took years to build the trade up as Yen was borrowed and the EUR bought since the turn of the Millennium. It may take months yet to unwind these years of accumulation. The process is not pretty. The damage wrought is enormous. The panic lies still ahead.
Moving on, the unwinding of the long EUR/short Yen cross is being made all the more dramatic as investors find reason to shun the EUR and investments in Europe generally as confusion regarding the EUR's future has leaped dramatically to centre stage. As we pointed out last week, Dr. Milton Friedman once said regarding the EUR... in which he tended to have very little confidence...that he doubted it would last through its first real recession. His fears are being put to test today. The world is testing the very mettle of the European confederation experiment, and investors the world wide are watching to see just how well the officials in Brussels and Frankfurt can resolve their large and growing differences.
When the economic weather is mild, the "boat" that is a unified Europe runs pleasantly upon the water. The passengers may be a bit unruly, and they may argue amongst themselves, but their arguments rarely will tip the boat for at least the waters are calm. However, when the waters around the boat are riled, the least bit of unruly activity amongst the passengers is amplified and made serious. When the waters are riled, what would have passed for mere annoyance during periods of quiet become life-threatening instead. We are at that point.
The unravelling began last week when Ireland, fearful of a run on its capital markets, touched off by the frightening weakness of her stock market last Monday, moved to guarantee all deposits within the Irish banking system. The other nations of Europe, then fearful that capital would logically rush to Ireland to seek protection, said that Ireland's decision was at best unwise, perhaps un-European and unconstitutional, and simply downright wrong. They protested. Frankfurt and Paris led the way. Mr. Trichet said that Ireland's unilateral decision was wrong and that all decisions of this matter should be a pan-European decision, not a parochial one. Confusion, as we have always, said, breeds contempt, and with that confusion the EUR came under assault.
Matters have gotten worse... and indeed much, much worse over the weekend, for Germany, having taken Ireland to task only last week, moved to follow Ireland's lead as Chancellor Merkel moved to guarantee all deposits in Germany. She really had no choice. Acting to stem these swift changes in the European banking landscape, the EU's Competition Commissioner, Ms. Neelie Kroes, said that blanket guarantees on bank deposits by individual countries within the European Union shall be considered "discriminatory." Mr. Kroes made her comments on Dutch television over the weekend.
Ms.Kroes said that Ireland is moving to change its deposit insurance plan so that it will conform with European rules, although we have not seen in what ways Dublin is moving... or even if Dublin IS moving at all. Were we Dublin, we'd not change, for our first responsibility is to the depositors in Ireland's banks and to the Irish capital markets, not to depositors on the Continent. Ms. Kroes said that on television that
We are now in close contact. My people were in Dublin on Friday and Saturday and returned with reports that changes will be made.... A guarantee without limits is not allowed ... [but we expect] that it will be brought into a form for which we can together state that it is in line with the treaty.
Germany disagrees with Ms. Kroes and Brussels, apparently, for a spokesperson for Germany's Finance Ministry, Mr. Torsten Albig said over the weekend that "The state guarantees private deposits in Germany" while a second spokesman said the guarantee was and can be unlimited. Now that Ireland has moved in this fashion, and now that Germany has followed, Greece has said that it shall also. Others will follow, overwhelming Brussel's ability to protest Ireland's and Germany's decisions, and thus forcing Ireland to take other actions to continue to draw capital to her. Ireland's Finance Minister, Mr. Brian Lenihan, openly defended his government's plan to guarantee the deposits and debts of six Irish-owned banks for the next two years and pointed to the panic felt by investors over Irish financial stocks this week. We can find no fault whatsoever with Mr. Lenihan's position. Were we he, we'd do precisely the same thing... perhaps even a bit faster.
And from my friends at Gavekal:
Was it just ten days ago that Peer Steinbruck railed at the US for the banking crisis and mentioned that, because of the pneumonia in the US, Europe may well have to endure a cold? Ten days later, a cold seems like wishful thinking. Instead, it looks as if the US pneumonia is inflicting a serious case of tuberculosis across Europe!
In the past ten days, not only have we seen European governments forced to offer blanket guarantees for depositors in banks (e.g., Ireland, Greece...) but we have also witnessed a number of banks coming hat in hands to their respective governments (Hypo Real Estate, Glitnir, Fortis, Dexia, Bradford & Bingley...). Which of course begs the question of what the respective European governments can do? Some (Finland, Holland...) with overall low government debt and small budget deficits, can afford bank bail-outs. For others, whose economies may already be in a recession (e.g., Italy, Spain, Ireland...), financing large-scale bailouts may be more of a challenge. Which brings us back to a long-standing GaveKal theme, namely how the (no) Growth and Stagnation pact (see The European Divergence Trade) hampers EU governments from taking necessary action in the face of a banking crisis. Worse yet, in Europe, investors simply have no idea who the lender of last resort is, or if there is one. And, as we are finding out, this question is no longer a rhetorical question. After all, if the numbers bandied about by Der Spiegel of a necessary €100bn to recapitalize Hypo Real Estate (and that is just one bank!) are even close to the mark, where will the money come from? As we see it, there are two possible options:
- The first option is that the ECB prints money aggressively to finance a European-wide bank bailout. This could prove rather inflationary for the Old Continent as wages there tend to be very sticky. It would also entail an absolute collapse in the Euro.
The second option would be for the ECB to tell the various European governments that the banking mess is their own problem, and that they have to deal with it. This would most likely entail a continued divergence in the yields at which European governments borrow (currently standing at post-Euro introduction record highs). - And this brings us back to a long- standing GaveKal theme: for the Euro to survive, either a) it will have to be a structurally weak currency or b) some of the weakest links (i.e.: Portugal? Italy? Greece? Spain?...) may end up being forced out. The path of least resistance is, of course, for the Euro to a structurally weak currency.
Which seems to be where we are heading. Indeed, despite the baffling decision by the ECB to maintain rates unchanged last Thursday, the Euro has been in a serious freefall against the US$, CHF, Yen, etc... Of course, this weakness could also be a sign that the ECB, with its stubborn unwillingness to adjust monetary policy in the face of rapidly changing events, has seriously undermined investor confidence in the Euro area. After all, 48 hours after the ECB board met, the rescue plans for both Hypo RE and Fortis were struggling. Surely, the ECB had to know that two major banks were in dire straits? Or was the ECB board drinking the same Kool-Aid as Peer Steinbruck?
However one cuts it, it is hard to escape the conclusion that Europe is not only experiencing its own credit crunch, but will experience a nasty recession. This recession will put most European government budgets into serious deficits; foreign investors may thus start to question the logic of owning the debt of governments whose balance sheets and income statements keep on deteriorating, and whose currency is free-falling? Milton Friedman once said that the Euro would likely not survive its first major "bump in the road". We will soon find out. The great "European Divergence Trade" is no longer about theory; it is happening before our very eyes.
And from Wolfgang Munchau in today's Financial Times:
This has been a week of self-congratulation in Europe. We have saved a handful of banks. We have, in effect, started to cut interest rates. We even had a summit of European leaders that produced warm words of solidarity. It looks as though the Europeans have reached substantive agreement that no systemically important bank should ever be allowed to fail....The rescue of Fortis and Dexia last week, two large, but not too large, cross-border European banks, should be seen as a sign that our emergency procedures are working. Look, they say, we met quickly and decided what needed to be decided. It was fast and unbureaucratic. We do not need a European rescue fund, let alone any new institutional set-up to deal with this, they say. We can do it ourselves.
I agree that the few ad hoc rescues have worked. But do not fool yourself. They worked because they were the first wave of rescues and because they involved banks such as Fortis - of just the right size, based in just the right small- to medium-sized country where political leaders are sufficiently rational not to hold each other to ransom as midnight approaches on Sunday.
But what if this had been a bank with a name of a large European country, or an acronym that refers to a large European city, banks that are simultaneously too big to fail and too big to save? I shudder to think what would happen when Silvio Berlusconi, Angela Merkel, Lech Kaczynski and the next Austrian leader have to meet to discuss the future of a large cross-border European bank.
What worked for banking rescues numbers one to five may not work for rescues number six to 50 - the estimated number of systemically important banks in Europe. And that number does not include some banks we have already rescued, which politicians judged to be important for their domestic banking system, like Germany's IKB Bank, but with no European relevance whatsoever. We have been squandering money.
Nor does it include the likes of Hypo Real Estate, which is not even a bank at all....
The Europeans are of course right in their overall ambition not to allow systemically important banks to fail. They are also right in their scepticism about their ability to distinguish between illiquidity and insolvency during an emergency. But I fear we are still well short of a strategy. We might be lucky, and scrape through what could well become the most dangerous month of the crisis so far. If, for example, the credit default swap market were to blow up in the next couple of weeks - a non-trivial probability - we have no plan.
Nicolas Sarkozy, the French president, was therefore right when he appeared to back a €300bn rescue fund. Regular readers of this column will probably recall my somewhat constrained enthusiasm for his economic policies. But this had the makings of a good plan. He ended up distancing himself from it, when it became clear that Angela Merkel, the German chancellor, would not support it. But he was right and she was wrong. Of course, a European plan should not have been a copy of the bail-out that was finally adopted by Congress on Friday. The US plan failed to address the problem of an undercapitalised banking sector. That issue is even more important in Europe where many banks have an extremely weak capital base, with leverage ratios of 50 or more.
Europe does therefore not need any bail-out plan, but a plan that specifically addresses the capitalisation problem. Concretely, three things are needed: the first and most important is money. A sum of €300bn will not cover the EU in a worst-case scenario, but it is a sensible number to start with; secondly, you need a semi-permanent crisis committee empowered to take decisions; and finally you need a strategy to apply symmetrically and based on clear rules about when to recapitalise, and when not.
If you pursue a strategy of taking purely national decisions, you run the risk that at least one government will hit its own financial ceiling before this crisis is over, or that decisions have negative spillovers on the banking systems of other countries. Moreover, you end up with a beggar-thy-neighbour regulatory race, as we saw last week when Ireland and Greece unilaterally issued blanket guarantees for large parts of their banking sector. Last night, Germany was preparing a full deposit guarantee for its own banking system. Last but not least is the risk of violent political setback against a process that lacks transparency.
For Europe, this is more than just a banking crisis. Unlike in the US, it could develop into a monetary regime crisis. A systemic banking crisis is one of those few conceivable shocks with the potential to destroy Europe's monetary union. The enthusiasm for creating a single currency was unfortunately never matched by an equal enthusiasm to provide the correspondingly effective institutions to handle financial crises. Most of the time, it does not matter. But it matters now. For that reason alone, the case for a European rescue plan is overwhelming.
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