EconoMonitor

Spurious Data

They tried to make me go to rehab and I said “No, no, no”

We found it curious that in the days since S&P downgraded the US, the S&P has recovered all but 50 points of its drop and the US 10-year yield has gone from slightly over 2.50% to below 2.10%.  We feared that the bond market had it right, signaling not just a flight to safety but lower expected growth; it would be only a matter of time before the S&P followed. Yesterday, Thursday August 18th has reversed all that. At the time of writing, the chart on the Exhibit 1 is outdated by 24 hours and the S&P is in the midst of a massive selloff (on Thursday, the S&P closed down 4.46%) while bonds continue to rally.  Meanwhile, the European Union continues to be sustained by ECB sovereign bond purchases that will likely stave off default but which have done little to help lower rates. Greek August 2012 bonds now trade at over a 40% yield while the country’s five-year CDS now trade at over 1900 bps (on Wednesday it was only 1800 bps).  We have long questioned the situation with European banks, noting that those who downplay the connections with US financial institutions miss the point. Banking is a confidence game and when one’s confidence is shattered, contagion often runs rampant. Several questions arise from the current state of events.  What will happen to US rates over the next twelve months?  What is the prospect for US companies? Will Europe be saved and what are the alternatives?

Exhibit 1: Stock Price Index (Red, LHS), 10yr Treasury Yield (Constant Maturity, Black, RHS)Exhibit 1 - Policy Quagmire

Sources: US Treasury/Haver Analytics

US Debt Outlook:

With its latest attempt at ZIRP (Zero Interest Rate Policy) the Fed has basically ensured that US rates will stay low and that the curve will flatten with long end rates coming in.  Our bold new forecast is for the US 30-year Treasury to fall below 2.75% in the next twelve months and for the 10-year to fall below 1.8%. How long rates stay this low depends on how simulative low rates are on the real economy in the US as well as what type of asset price inflation they bring about globally.  Low 10-year rates in late 2008 and the middle of 2010 helped to spur price increases for hard assets such as oil and gold as well as other non-productive assets such as wine and art.  One could also argue they contributed to growth along with fiscal stimulus. Now that there is no fiscal stimulus we wonder if low rates alone will spur any sustainable growth activity.

In an ideal world, banks would take advantage of low interest rates and the steep yield curve to lend.  They could borrow from the Fed at close to zero and lend out at Libor plus.  But as we can see, although the past three years have resulted in a steeper 2s-10s spread; it has gone from 100bp in early ‘08 to over 250bp earlier this year. All the while, corporate lending has declined.  As Albert Einstein once said “In theory, theory and practice are the same, in practice they are not.”  In fact it seems that low interest rates have merely encouraged liquidity in risky assets rather than providing funding for capital investment that will lead to future growth.  Put another way, if money is spent building a new factory or on R&D or on some productive asset it has a much greater chance of creating future growth than if it is used to purchase fine wine or gold.  Even the purchase of stocks has a transitory impact as any number of global or domestic events can reverse the good fortune of the stock market leaving wealth destruction in its wake.  The over 4% drop on Thursday serves as a reminder of this fact.

Exhibit 2: 2s-10s Yield Spread (%, Red, LHS), US Bank Loans Less Mortgages (Billion USD, Black, RHS)
2s-10s Yield Spread

 

Sources: Federal Reserve, FDIC/Haver Analytics

Of course what we cannot do is measure what would have happened if the Fed had done nothing. We have no counter factual.  Perhaps lending would have fallen further, certainly corporate bond yields are unlikely to have fallen to the levels they have. Corporates that have had access to the capital markets have borrowed there and been able to reduce interest costs and improve cash flow as a result, but will they employ the money for productive use or are they willing to hold cash?  So far it seems they are willing to hold cash.  This reminds us eerily of Japan circa 1997-2003 where repeated insufficient attempts at stimulus and structural adjustment resulted only in high government debt levels, low growth rates, bouts of disinflation and financial repression.

Exhibit 3: 10yr Treasury Yield (%, Red, LHS), Japan 10yr Yield (time-shifted Jan ’97-July’03, %, Black, RHS)Exhibit 3 - Policy Quagmire

Sources: US Treasury/Bank of Japan/Haver Analytics

We believe that low rates will only help spur growth if households and businesses feel confident enough about the future to borrow. Herein lies the problem. Dysfunction in Washington and a continued mess in Europe plague confidence which hurts  real economic activity. It is likely that if neither the Japanese tsunami nor the Arab Spring occurred the recovery would be on a much stronger track.  These two shocks, to supply chains and oil prices, were enough to derail a fragile recovery.  Now we are left with fiscal austerity and continued loose monetary policy in the US and fiscal austerity and confused monetary policy in Europe.

As to the situation in Europe we see three basic catalysts for a breakup of the Euro. The first is what we have been calling a “bank walk” where money steadily trickles out of a market (Ireland came to the ESFS as a result of a bank walk).  The problem with the bank walk is there is no solution; Europe does not have equivalents of the OCC and FDIC to quietly handle bank failures in order to safeguard the system. We believe the rules implemented in October 2010 and the meager deposit insurance system are insufficient to deal with the current banking crisis. Sensing this inadequacy, the New York Fed is demanding that European banks give it details about access to funds. An article in the Wall Street Journal on Thursday highlighted the dependence of European banks on the Fed’s liquidity measures of the past year; European banks have increased reserve balances twofold to nearly $900bn as of July 13th. Worryingly, that figure has dropped 16% to $758bn as of August 3rd and many suspect that it highlights a need for dollars.  Should a major European bank fail, it would ripple through financial markets globally and it could well mean a smaller Euro-zone.

Our second concern regarding a European catalyst is politics.  Politics will be critical in deciding if Europe can create Euro-Bonds. Politics will be important in deciding if current leaders will be re-elected.  And politics is important in deciding anything regarding Europe’s future.  Recently Finland was able to require collateral for any monies it put up to rescue Greece. Predictably other countries want collateral guarantees as well.  This is one more fly in the ointment but perhaps one that ultimately prevents throwing more good money after bad.  As the German paper Der Spiegel pointed out Thursday “For some time now, the Bavarian conservative party has sought to foment fears about the euro, using a tone not too distant from that of the euroskeptic right-wing populist parties who have recently been gaining ballot-box traction across Europe with their messages.”

Finally, we believe the ECB policy of purchasing European Government bonds is a mistake.  Europe should let Portugal and Greece leave the Euro so they can focus on saving core countries like Spain, Italy and possibly even the French banking system.

Both the Europeans and the Americans should take heed to what Christine Lagarde said in her August 16th op-ed in the Financial Times. To us the core of her article is about being able to grow our way out of the cyclical and structural deficits we now face.  She wisely says “Decisions on future consolidation, tackling the issues that will bring sustained fiscal improvement, create space in the near term for policies that support growth and jobs.”  For the US it is time to consider some sort of public works/infrastructure public-private partnership that will put many back to work.  It is difficult to imagine in the current political environment, but if fashioned correctly it is not altogether impossible.  In Europe we believe that Greece, Ireland and Portugal should no longer be supported. These countries would experience more pain in the short-term from a market based restructuring, but it would save the rest of Europe and would likely cauterize the crisis.  These would each be bold moves, but with equity markets down between 5-7% across Europe and the US in two days time and with economic growth stalled to the point where a new global recession is easily imagined, bold moves are required. The real question is how does the body politic galvanize to make bold choices possible so the economy can get through rehab and begin to thrive again?

<!–[if gte mso 9]> Normal 0 false false false EN-US JA X-NONE <![endif]–><!–[if gte mso 9]> <![endif]–> Both the Europeans and the Americans should take heed to what Christine Lagarde said in her August 16th op-ed in the Financial Times. To us the core of her article is about being able to grow our way out of the cyclical and structural deficits we now face. She wisely says “Decisions on future consolidation, tackling the issues that will bring sustained fiscal improvement, create space in the near term for policies that support growth and jobs.” For the US it is time to consider some sort of public works/infrastructure public-private partnership that will put many back to work. It is difficult to imagine in the current political environment, but if fashioned correctly it is not altogether impossible. In Europe we believe that Greece, Ireland and Portugal should no longer be supported. These countries would experience more pain in the short-term from a market based restructuring, but it would save the rest of Europe and would likely cauterize the crisis. These would each be bold moves, but with equity markets down between 5-7% across Europe and the US, and with economic growth stalled to the point where a new global recession is easily imagined, bold moves are required. The real question is how does the body politic galvanize to make bold choices possible?

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