The Fall of Sacred Cows
As global events unfold, the underlying premises which have guided market participants’ reactions to bureaucratic actions are being put to the test and are coming up short. This is going to get a wee bit technical, but bear with me and it will all come together after a few paragraphs.
Last week the European sovereign debt crises push central banks across the world, (the Fed, the ECB, Bank of England, Bank of Japan, Bank of Canada, and Swiss National Bank) to move in concert to cut the rate on U.S. dollar liquidity swaps by 50 basis points. Now European banks can borrow dollars at a slightly lower rate and phew, all is saved! Really? Interbank lending has so utterly frozen up that on Friday we saw in an ECB data release showing that banks had borrowed more than 8.6 billion Euros overnight from the Central bank and usage of the ECB’s deposit facility rose to over 300 billion Euros this past week. This shows that banks, much like in 2008, have become increasingly wary of lending to each other and prefer the essentially non-existent rates on their reserves. Think about that, banks are afraid of lending to each other, even overnight! This move by central banks simply addresses the symptom, liquidity, and does nothing to resolve the real problem of insolvency.
Yet we keep being assured that those wondrous politicians will work it out. So then does anyone have an explanation for why aggregate central bank purchasing of gold bullion was a record 148.3 tons in Q3, with purchases in 2011 on track to be the biggest year since Bretton Woods failed over 40 years ago? What do they know? (Sarcastic tone intended.)
I believe it is clear that the half-point easing of rates by the central banks last week only buys a little more time and underscores just how fragile the global banking system has become. Bank nationalizations and a rather dour recession are likely in Europe’s near future.
Yet the stock market rallies! Remember that from late 2007 to early 2009 there were four such swap extensions or expansions which initiated, in aggregate, a total of about 3,000 point rallies in the Dow, yet over the entire period the Dow fell 50%. By the time the market bottomed in March 2009, the recession was coming to an end. The European recession is just getting started and the combination of drastic austerity measures and credit contraction is likely to ensure that this one is going to sting something awful!
So why the market joy? There are two facets to understanding major macroeconomic events: the data and the interpretation of the data. The data is simple and quantifiable. The interpretation is entirely different in that it requires a set of base premises through which one determines the meaning of the data. For example, I walk outside in the morning and the ground is wet. If I live in Seattle, I will likely surmise it rained or there was a heavy fog the night before. If I’m in Vegas, I’m more likely to start hunting for a broken sprinkler head. Thus the fact, wet ground, is interpreted through my internal paradigm.
The markets these days are driven in large part by the beliefs of the participants. The fundamental data is abundant and torpid, but the interpretation is far more capricious. The data is evolving in such a way as to contradict some previously unquestioned beliefs. In the face of such unnerving events, it is not surprising to see that these beliefs are hard to shake and beliefs are struggling to catch up with the evolving fundamentals. As the data degrades sufficiently, these underlying beliefs can rapidly and violently change a situation from bizarrely benign to an overnight crisis.
One such premise is the belief that since a default on the debt of the larger developed nations would be incredibly painful, bureaucrats will never allow it to happen. This belief hinges on a seemingly unquestioned belief that bureaucrats are essentially omnipotent; if they will it, it will be so.
If we look at the larger picture of global debt, it is clear that we have reached the largest accumulation of peacetime debts in history, so there is no playbook to help anticipate what will happen next. With wartime debt, the victor gets the spoils, facilitating debt pay-downs, and the loser is mired in defeat and default. The total global credit market has grown at an over 11% annual compound growth rate since 2002, while GDP has only grown at about 4%. There is currently no nation in the world with a sufficient pool of disposable capital at hand to stave off a major crisis in the global debt super cycle. Hard defaults are likely unavoidable, despite the bureaucrat sound bites. It is absolutely astonishing to see central banks attempt to assure that markets that all will be well as heavily indebted nations will most certainly provide money, that they themselves don’t have, to bail each other out. What sort of logic makes this math possible?
Let’s look at a few specifics. The ECB has been purchasing Greek Bonds since May 2010 and now owns 40% of all outstanding Greek debt. During this time the Greek 10-year has risen from as low as 6.34% to almost 32%. If this level of purchasing couldn’t contain the debt of a nation as small as Greece, why would anyone believe that larger economies will be more successful? Just because this time, they really mean it? The IMF claims that it has around $385 billion available to provide aid to member nations. Italy, the seventh largest contribution to the IMF, needs around $800 billion!
Bottom Line: We are watching the apoplectic fits that are characteristic of a bear market with the additional volatility one would expect as sacred cows of bureaucratic belief fall before our very eyes.
