Monday, June 25, 2012

Will Euro Dithering Lead to Global Deflation?

Stocks slid in early trading on Wall Street Monday, following global markets lower, after Spain requested help for its struggling banks. Bloomberg reports Treasuries rise as Soros warns Euro is at risk:
Treasuries rose, extending a quarterly gain, as investors sought refuge amid speculation European leaders will fail to make progress at a two-day summit on stemming the euro bloc’s debt crisis.

Longer-term bonds extended their advance after a report that Moody’s Investors Service plans to downgrade Spanish banks. German Chancellor Angela Merkel rejected joint euro-area bonds or bills, saying that introducing shared debt in the 17-nation currency region now would be “counterproductive.” The U.S. will auction $99 billion of notes this week.

“The market is stepping back from any meaningful expectation for anything from the summit,” said Ian Lyngen, a government-bond strategist at CRT Capital Group LLC in Stamford, Connecticut. “We are back in a risk-off mode until there is a reason not to be.”

The 10-year note yield fell six basis points, or 0.06 percentage point, to 1.61 percent at 10:45 a.m. New York time, according to Bloomberg Bond Trader prices. The 1.75 percent note due in May 2022 advanced 18/32, or $5.63 per $1,000 face amount, to 101 1/4. The 30-year bond yield dropped eight basis points to 2.69 percent.

Treasuries remained higher even after sales of new homes in the U.S. increased in May more than forecast, rising 7.6 percent to a 369,000 annual rate. A Bloomberg News survey projected a rate of 347,000.

Ten-year yields have fallen 60 basis points this quarter and have lost 26 basis points this year.

Expensive Securities

A valuation measure showed the benchmark notes trading at almost the most expensive level ever. The term premium, a model created by economists at the Federal Reserve, was at negative 0.86 percent, after reaching a record negative 0.94 percent June 1 as investors sought refuge from Europe’s debt turmoil.

A negative reading indicates investors are willing to accept yields below what’s considered fair value. The average over the past decade is 0.50 percent.

German 10-year bunds, the euro area’s benchmark government securities, also gained today as investors sought safety, with the yield dropping 12 basis points to 1.46 percent.

Demand for the safest assets has helped Treasuries beat all other U.S. fixed-income securities for the first time in three quarters.

Bond Returns

U.S. government debt has returned 2.9 percent since March, while corporate bonds returned 1.9 percent, mortgages rose 1 percent and municipal bonds increased 1.8 percent, according to Bank of America Merrill Lynch index data. The combination of Europe’s debt crisis, China’s slowdown and record stimulus by the Fed means Treasuries are outperforming the global bond market by 1.3 percentage points, after lagging behind by 2.4 percentage points in the previous quarter.

Treasury yields extended declines after the newspaper Expansion reported Moody ’s plans to downgrade Spanish banks by two or three levels today. The Spanish paper, citing an executive at a bank it didn’t name, reported the statement may come at around 11 p.m. in Madrid. An official at Moody’s couldn’t immediately comment on the report.

European leaders open their summit June 28 in Brussels. Germany’s Merkel said in a speech in Berlin today that the goal is a political union in Europe with stronger oversight. Proposals for joint euro-area bonds or bills and joint deposit insurance are “wrong and counterproductive,” she said.

‘Risk Off’

“It’s the risk-off trade again,” said Justin Lederer, an interest-rate strategist at Cantor Fitzgerald LP in New York, one of 21 the primary dealers that trade with the Fed. “We go back and forth with concerns out of Europe. People want to be optimistic, but there’s just so much uncertainty.”

The billionaire investor George Soros said yesterday Europe should start a fund to purchase the bonds of Italy and Spain in return for budget cuts in the nations. European leaders are running out of time to show investors they will do what’s necessary to save their currency, he said in an interview in London with Bloomberg Television’s Francine Lacqua.

“There is a disagreement on the fiscal side,” Soros said. “Unless that is resolved in the next three days, then I am afraid the summit could turn out to be a fiasco.”

The Treasury will sell $35 billion of two-year debt tomorrow, the same amount of five-year securities the next day and $29 billion of seven-year notes on June 28.

Operation Twist

The Fed plans to sell as much as $8.75 billion today of Treasuries due in March to October 2014 as part of its Operation Twist program to cap borrowing costs, according to the Fed Bank of New York’s website.

Central-bank officials led by Chairman Ben S. Bernanke last week extended the program, which is replacing $400 billion of shorter maturities with longer-term debt through the end of this month, until year-end. They increased it by $267 billion.

The difference between yields on 10- and 30-year Treasuries shrank to 107 basis points, from 109 on June 22. The spread has narrowed from this year’s high of 1.23 percentage points in May, known as a flattening of the yield curve.

“We believe it is not yet fully reflecting the demands shock from a six-month extension of Operation Twist, implying that the curve has room to flatten,” Anshul Pradhan and Vivek Shukla, analysts at the primary dealer Barclays Plc in New York.

The spread between 10- and 30-year yields is testing resistance at the 200-day moving average at 108 basis points, according to data compiled by Bloomberg. A break below that may mean a move toward the June 5 low at 103 basis points, the data show. Resistance refers to an area on a chart where technical analysts anticipate orders to sell a security to be clustered.

Another week dominated by news coming out of another Euro summit. It's quite depressing watching European leaders dither while Rome burns. In my last comment on treating life as an experiment, I mentioned rumors of a 2 trillion euro bailout bazooka, but also cautioned Germans are increasingly weary of bailing out their southern neighbors.

Erik Kirschbaum of Reuters reports, Schaeuble says "no" to throwing money at euro crisis:

Throwing more money at the eurozone debt crisis will not solve the problem because the troubles have to be resolved at the cause, German Finance Minister Wolfgang Schaeuble said on Sunday.

Schaeuble also said in an interview with German TV network ZDF that Greece has not done enough to fulfill promises it made in exchange for bailout funds. Schaeuble also criticized the recent interventions by U.S. President Barack Obama.

"We have to fight the causes," Schaeuble said. "Anyone who believes that money alone or bailouts or any other solutions, or monetary policy at the ECB -- that will never resolve the problem. The causes have to be resolved."

Schaeuble added: "It's not going to help to take money to it. The decisive thing is to credibly fight the causes of the crisis. It's succeeding very well in Ireland and Portugal. It's not succeeding very well in Greece. But it must succeed in Greece. There's no other way to do this."

Schaeuble said Greece has clearly not done enough.

"Greece hasn't tried enough so far, that has to be said quite clearly," Schaeuble said. "That has to be said with respect for the domestic political difficulties. But no one on earth who has followed this issue would think that Greece has fulfilled what it has promised.

"Italy and Spain are different on this question," he added. "They're making great reform efforts."

Schaeuble dismissed advice from U.S. President Barack Obama, who has called on Europe to do more to fight the crisis.

"Mr. Obama should focus on reducing the American deficit," Schaeuble said. "It's higher than in the euro zone. You have to understand that people are always ready to give others advice quickly. Our argument is 'we're ready' (to do more). We want more Europe."

As I stated in my last comment, Schaeuble is right that Greece hasn't done enough to rein in the bloated public sector, but he also fails to mention the Greek bailout is nothing more than a corporate handout to German banks and companies.

A friend of mine shared these insights:

Schaeuble is somewhat disingenuous. It takes two to tango in a default, borrowers and lenders.

The bailout loans to Greece were actually bailout loans to the French and European banks who had extended way too much credit and did not have strong enough balance sheets to support a default. In effect, the bailout transferred a large proportion of the risk from the banks to the EU, IMF and ECB.

Once enough of the risk was transferred from the balance sheets of the French and German banks and their balance sheets were strong enough to absorb a haircut, the troika forced a “voluntary” haircut on the remaining private sector debt.

End result is Greece has been a pawn in a larger game. They are stuck with a large amount of sovereign loans rather than private sector debt. Why is this important? Historically, there are no haircuts on sovereign loans only renegotiation of the terms (i.e. lengthening of tenor and lowering of interest rates).

The only way for Greece to gain the upper hand is to generate a primary surplus. Once this is achieved and the country is no longer dependent on debt to fund their day-to-day obligations, they will be in a better negotiating position to execute an orderly restructuring of all their debt with favourable terms which is sustainable in the long term.

Unfortunately, it's not the austerity measures that is the ongoing problem in Greece. It is how they have been implemented. Wherever possible, the government consistently favoured applying measures onto the private sector creating a scenario whereby government revenues have been falling faster than expenses and the primary deficit remains intact.

I sometimes wonder if the French and German governments were fully cognizant that the Greek government would continue to do what they had done in the past. This minimized the damage to France, Germany, and the rest of Europe (even if it increased the hardship on Greece).

Unfortunately, we have no one else to blame but ourselves. Greece had its fate in its own hands over the last three years and no one stepped up.

The only hope now is to position the country at some point to generate a primary surplus. I am not hopeful. The first announcements made by our newly minted government just continues along the same political appeasement path ... the civil service will not be touched.

Anyway, not a good start. At least, the country is not in a full meltdown which is what would have happened if Syriza was in power.
And my uncle in Greece, a self-employed businessman, shared this with me:
Greece is applying strict austerity measures, it is already in deep recession and the GNP has dropped last two years about 20%. The unemployment is over 21 %.

It is true that measures taken are not enough due to the reaction of some populist-demagogues politicians and also syndicates.

On the other hand political instability and two general elections during last two months have caused some delays.

Let us hope after the creation of a new pro-European coalition government things will move faster.
One can only hope as Bloomberg reports Greece
may have to wait at least another five years before it can sell bonds to investors, according to financial institutions that trade debt with European governments.

But the power and fate of the global economy lies in Berlin, and if Germany doesn't quickly abandon its illusions, and growth policies aren't implemented on a global scale, you can bet that the next big trend is deflation:
The world is awash in debt that probably can't be repaid, leading many investors to fret that central banks will one day soon come to the rescue by easing the plight of borrowers through a massive amount of money printing, in effect inflating the debt away.

Worries about just such an outcome have led many investors to believe that the current, debt-driven economic crisis will most likely be resolved through inflation, engineered by central banks. Having more inflation would make the debts easier to service and less onerous. It's the argument gold bugs often make when they claim fiat currencies are doomed and everyone should have a stash of bullion, along with a gun and a supply of canned goods.

But Comstock Partners, a U.S. money manager, says forget about an inflationary resolution to the debt problem. The most likely next big trend, in their view, is deflation, or falling price levels. They believe deleveraging, or the elimination of debt either through repayment or bankruptcy, will lead to deflation.

"We have long maintained that a debt bubble followed by a credit crisis leads to a deflationary recession or depression, and a major secular bear market," the firm said in a recent letter to clients. "In our view, it is the overwhelming force of the debt deleveraging that has overcome government efforts to inflate."

While deflation hasn't happened yet in Canada, it might be getting close. The May CPI numbers reported today showed consumer prices fell 0.2 per cent from April and were up a mere 1.2 per cent over the past year. Japan has been experiencing deflation for years, and Switzerland has been starting to experience falling consumer prices as well.

Comstock's report makes an interesting observation. So far, governments and monetary authorities have tried nearly every trick they have to jump start the global economy, but it hasn't worked.

There have been massive deficits, two rounds of quantitative easing, or money printing, by the Federal Reserve Board and just this week it announced an extension of Operation Twist, another Treasury bond purchase program. In the U.S., the Fed has tripled the monetary base, without leading to runaway money supply growth or much economic growth, for that matter. Something is working against the efforts by policy makers.

Comstock thinks it has the answer: people are trying to get out of debt (witness the fall in household debt in the U.S. to 84 per cent of GDP recently, from its peak of 98 per cent in 2008).

If consumers are using their money to repay debt then they're not buying things, so the demand for goods is weak, so businesses have little reason to hire or make capital expenditures. This sets up a vicious circle of weak demand that starts to feed on itself and is difficult to arrest. Deleveraging still has a long way to go for household debt to even fall back to the 55 per cent of GDP average over the past 60 years.

"Under these circumstances, we believe that inflation cannot take hold in the real world. Businesses feel minimal pressure from rising wages and have no compelling need to raise prices. Even if they tried, consumers would not have enough income to pay the higher prices and would resist, forcing producers to rescind whatever price increases they try to put through," Comstock says.

You can read Comstock Partners' special deflation report here. Before you dismiss it, think about why bond yields are continuously going lower. The world is awash of debt and the risk of policy mistakes (ie. focus on mindless austerity) risks throwing us into a multi-decade deflationary depression.

Below, George Soros speaks to Bloomberg's Francine Lacqua ahead of the EU summit to give his blueprint for the eurozone. Also embedded clips Yahoo interviews. One with Gluskin Sheff's chief economist and strategist David Rosenberg who claims 'modern-day depression is here' and Jerry Webman, Chief Economist at Oppenheimer Funds, who says don't count on consumers to save struggling economy.


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