Repeat ad nauseam

The last week or 2 have become so repetitive that there's little new to cement on, but some elements of Europe's gran plan are becoming clear.

The ECB will never directly lend to governments by buying their bonds in the primary market.

They will however continue to "stabilize" the market by buying on dips in secondary.

They will also led indirectly through Europe's banks via the new 3 year lending facility. This allows banks to lock in cheap funds and use them to buy government bonds, earning a handsome spread at the same time. This funds governments and allows banks a nice fat profit with minimal capital use to effectively rebuild their balance sheets.
As long a the sovereign bonds in question don't default first of course.

And therein lies the rub.

Personally I think the plan will work but it will take time. That is always going to be a problem when facing a hyperactive and hypernervous bond market, but it's time supposed market professionals for their heads round the fact that there is no quick fix to this. It's going to take a long time to fix both the banks and the governments.

3 years ago governments bailed out banks. Now it's time for banks to return the favour.

Happy Christmas

More imperfect evidence

I can't help but notice that the airwaves here in Singapore are suddenly full of adverts by car companies with offers of free insurance, free tax and free petrol.

To top it off, COE peices are falling for those not in Singapore, COE stands for certificate of entitlement. This is a 10year permit that allows you to put a car on the road. Here in Singapore cars are rationed strictly, and buyers of new vehicles have to buy a COE before they can put their new car on the road. COEs are sold twice a month on an auction basis, and so are a pretty good indicator of immediate economic health and confidence. And prices are falling, admittedly only from 75k to 72k, but only a month or 2 ago people were talking 100k. I have a theory that COE prices are only still so high because car importers are registering their cars and then struggling to flog them.

Singapore is calming down, and Singapore is the canary in the Asian coalmine. If Singapore goes into reverse then Asia is in trouble.

Dont mention the war

It's 1939 again. Britain stands alone against the forces of Europe, marshalled by Germany. Except this time both Germany and Britain are right. Ish.

Germany are right to refuse the idea of "Eurobonds" and Britain are right to stand against the move to federalism.

Eurobonds make no sense without at the very least fiscal federalism first. Why would any country agree to underwrite issuance by another country without control over that country's spending and borrowing? A moments thought reveals that to be self evident. Without that what is to stop governments going on reckless spending sprees off the back of northern European fiscal prudence?

And Britain is right to veto the idea of being tied into the same fiscal system as the Eurozone members. Britain's biggest asset right now is sovereign control over its own currency, budget and economy. Giving that up without getting something in return makes no sense.

There is a lot of talk about a "two speed Europe" now that Britain has exercised its veto.

I think that is right, but not in the way Europeans are portraying it. The beneficiaries are the Plucky Brits. A flexible labour market, a flexible economy, continuing membership of the European Union with its attendant free trade zone, strong ties to the slowly recovering US economy, a government that got on top of its debt problems early, a very low refinancing need due to the long average maturity of UK government debt, and lastly control over its own currency mean the UK is likely to recover sooner and faster than a Eurozone which is only now facing up to its problems, and then reluctantly.

The Germans are right

The only country that seems to get the full implications of the last 3 years is Germany.

Rather than rushing in and throwing good money after bad in a desperate hope of stimulating your way put of the mess, the Germans realise the fundamental problem is too much dent, and the only solution is for that debt to be paid off. That means belt-tightening and pain all round, for many years.

At the risk of stereotyping, the Germans have always been prepared to buckle down and put in the hard work. The Anglo-Saxon model of quick fixes and instant gratification fueled by debt got us in this mess. Time for a try of the German model, with some pain now, rather than even more pain in the future.

Light at the end of the tunnel

I have a feeling we're finally getting somewhere in europe. Draghi has said the ECb will be more interventionist if there is a closer fiscal union. The recent surges in yields for Spanish, Italian, and most alarmingly French government bonds seem to have finally scared their respective governments into caving into German demands for that closer fiscal union.

I would expect some steps in the right direction will be announced after the Dec 9 summit, which in turn will allow the ECB to up its involvement with the implicit approval of Germany, on the understanding that the changes will be implemented (major changes of course require all 27 member countries to ratify treaty amendments which can literally take years. The ECB will have to act ahead of that).

Meanwhile the market rallies of yesterday seem to be fading, and with good cause.

Only an equity investor could interpret coordinated central bank intervention in money markets, political statements that banks are facing a new credit crunch, and an easing in China in the face of slowing manufacturing and falling house prices as good news. Will they never learn?

We might be grinding towards some sort of movement in Europe, but whatever happens real growth in most of the western world is likely to be anaemic at best for years to come as the debt burden is paid off.

Some will point to recent manufacturing data from the US as evidence of a sustained recovery there which will drag the world along, but sadly it's largely an illusion created by huge and unsustainable government debt and deficits, and even if it were not, the US
is only about 25% of the world economy these days, and falling. It's still hugely important but it can no longer single handedly save the world. At some point the US will have to embrace big government cuts. The US economy is less reliant on government spending than many but the size of the cuts required to bring some sort of fiscal sanity to bear are bound to slow growth dramatically.

Low and slow will be the growth path
of the future.

Imperfect indicators.

I always ascribe more weight to anecdotal evidence than economists - pilots, shippers, hauliers etc always know way before economists when things are slowing down simply because most economists rely entirely on government-issued data which takes weeks or months to assemble. It's old news by the time it's published. But economists are a lazy bunch. Years of being feted and pampered by media and bankers has made them sluggish, so they just sit back and wait for "hard data" to tell them what has already happened, instead of going out and getting a feel for what's really going on right now.

Sometimes though you don't even need to go looking for it. Anecdotal evidence can be right in front of your eyes

And on that note, here are some snaps taken from the Singapore coast this morning. This is the parking area, where boats wait until they have a shipment to load.

There sure are a lot of boats out there waiting.... and waiting..... and waiting....

Terminal Velocity

As I mentioned in an earlier post, the success or failure of the Fed and Bank of England strategies of quantitative easing (QE - essentially buying bonds with newly printed money to pump cash into the system - a modern version of turing the printing presses on) rests entirely on the velocity of money. In essence that is simply how fast it turns over - how fast consumers spend it and companies spend or invest it. I mentioned in that same post that without any velocity, QE is useless.

It seems that in Europe velocity has collapsed to the point of being negative.

This makes nonsense of any arguments in favour of QE. It would almost literally be pushing on a piece of string. The only way out of this for Europe is for the ECB to turn on the presses for government bonds and buy the governments some time to set their fiscal houses in order. Attempting "stimulus" through purchase of corporate, financial or mortgage-backed bonds is pointless.

It is strange that European Banks can rely on the ECB for unlimited liquidity, but European governments can't.

Eventually ideology has to give way to practicality. Might as well make it sooner rather than later.

Contagion - coming soon to a government near you

Has the Euro disease broken free of the constraints of the currency?

Japanese bond yields are climbing (prices falling) as investors start to question whether Japan is ever going to get to grips with what is the worlds biggest government debt pile relative to GDP at over 250% (italy is just over 100 for comparison).

For 20 years Japanese central bank rates have effectively ben 0%, dragging down the yields on Japanese Government bonds to typically between 1 and 1.50% depending on maturity. Now however they're climbing sharply as investors extrapolate the european disaster to other economies.

I recall hearing or reading somewhere a year or so ago that if Japanese Government bond yields go to 4%, then 100% of government revenues will go on servicing the existing debt stock.

Of course there is one other country out there too with large debt stock, a large budget deficit and no apparent plans to do anything about either....

10yr Japan Govt Bond yields

Neither a lender nor a borrower be (or whatever the quote is)

I see the world's politicians are having another go at the banks for "failing to lend". US, UK, Eurozone - the message is the same everywhere.

What they don't seem to have realised is that banks can only lend money that they have. Their only sources of that cash are either deposits or borrowing in the bond markets - either short or long term.

The new rules, instigated by regulators at the behest of politicians mean that corporate deposits and short term bond borrowings are no longer regarded as core funding as so effectively can't be used to make long term loans.

Only retail deposits and long term bond issues count.

Retail is a bit strapped for cash right now. And he bond markets are effectively shut thanks to those self same politicians failing to get to grips with the Eurozone sovereign crisis.

Net result - banks can't lend even if they want to. The fact that they probably don't want to lend merely compounds the problem.

Deleveraging is coming to everyone, whether you like it or not.

China - damned if they do, damned if they don't

Interesting comment overheard over the weekend.

Every Central Bank / sovereign wealth fund is busy selling every European sovereign and agency ( such as European Investment Bank and European Bank for Reconstruction and Development) bond they have except the Chinese.

This isn't some sort of support for Europe though. China has the same problem in Euro-denominated bonds as it has in $ bonds - it owns so much of the bonds out there that if it starts selling the market will collapse and it'll end up costing itself billions. All the Chinese can do is sit tight and pray for a miracle. They are effectively all in to both US and European solvency.

The solution is obvious to everyone except those who need to see it

It's becoming farcical. To believe that Europe can somehow extricate itself from it's predicament without some form of mass monetisation of European sovereign debts is borderline insane. The only way it is achievable is by inflicting a mammoth depression on the whole of Europe, and by extension the world - Europe is after all 25% of the world economy, roughly the same as the U.S.. And it's not as though the U.S. is going to be able to take up the slack.

The ECB needs to relieve the pressure by stepping into the bond markets. That will give governments time to put their fiscal houses in order. Otherwise it's going to be a mess.

Doesn't seem likely to happen though. The Germans are dug in hard and won't give an inch. Ultimately this will hurt them too - Germany is a big economy but it is nowhere near big enough to support the whole of Europe - but they seem to prefer to share the pain than sacrifice their ideologies.

So what to do?

This is basically a rerun of Japan's classic credit bubble explosion of the late 80's and early 90's, and interest rates there are still at effectively 0% 20 years later.

Asset prices there are still falling.

Inflation is net to non-existent, and frequently negative, because as I have mentioned before, when companies and individuals start saving hard the velocity of money collapses.

The U.S. is making the same mistake Japan has made for 20 years. Using Central Bank buying and huge government deficits to try to provoke growth, when all they are doing is pushing on a piece of string.

Europe has an opportunity to do the right thing. Use Central Bank financing as a tool to buy time, not as a tool to attempt to stimulate. Once government deficits and debt piles are shrinking then the huge drag they have become on the economies will fade and growth will restart naturally. It may take a few years, but the alternative is Japan and U.S. style attempts to throw ever more borrowed money at the problem, which has been shown time and again not to work. Both those countries have been lucky that their domestic Government bond markets have held up - Japan's because it is effectively closed and the BoJ and Post Office mop up the bonds, the U.S. because the $ is the reserve currency of the world so most major institutions have little option other than to buy the currency and the bonds.

Europe is not so lucky. As Germany has just discovered, austerity is going to be spreading fast as markets simply refuse to buy new bonds. Imposed austerity would be a disaster as it would likely be severe. The ECB can buy time by acting as a lender. The austerity pill will still have to be swallowed, but the dose won't need to be as big up front and the taste not as bitter.

It is time to stop believing another recession can be avoided. It can't, and in fact it shouldn't be. It should be welcomed as finally cleansing the system of the excess debt of the 90s and 00s and allowing true growth to reassert itself.

Meantime, what to do.... whether the ECB steps in or not, interest rates in Europe and the U.S. are going to stay lower for longer than anyone (except me apparently) thought, and the world economy is going into a major funk.

Equity analysts are micro-analysis morons who have no idea what is coming.

Economists seem to be finally getting it but it's taking time.

Stay out of equities, stay long bonds - but not ones denominated in Euros.

German bond auction “disaster”

Yesterday’s auction of 10 year Bunds has been described as a disaster, and led to sharp declines yesterday in Europe and the US and today and Asia.

While disaster is possibly overstating it, it’s certainly not good news, and hopefully is wake-up call the Germans need. Germany has been caught on the horns of a dilemma for the past few months. It is quite clear the only way to save the eurozone is for the ECB to step in and buy Government Bonds openly in the primary and secondary markets, so capping rising government interest costs and giving those governments a chance to get their financial houses in order and implement much needed austerity plans. The alternative is the expulsion of many current members of the Euro.

The Germans problems are both legal and ideological.

Legally no country can leave the Euro – there is no mechanism to allow for it.

Similarly the ECB cannot fund European governments. Of course the ECB is already playing fast and loose with this by buying on the secondary market, claiming that is somehow different to buying at new issue.

Ideologically Germany is opposed to monetisation of debt buy Central Bank buying. They are concerned with 1930s style hyperinflation. And well they might be to be concerned, seeing as that hyperinflation led to the rise of Hitler. But as I said yesterday, there is no chance of hyperinflation in the immediate term. Velocity of money has collapsed. Individuals, companies and banks are hoarding cash and not spending. That is why QE is hopeless as a stimulus tool, but it also why EB buying of Government debt makes sense. It takes the panicked market makers out of the equation and gives governments time.

Once confidence is restored the ECB can either simply sell the bonds or let them mature and be repaid by the relevant government, keeping the money out of the system and preventing an inflationary spiral.

Germany needs to finally face up to this reality.

It will still lead to at least a Europe-wide recession as austerity bites, and probably a nasty one, but the alternative is far worse.

It’s time for everyone to accept that there will be no recovery for many years. This is going to hurt.

The voice of reason

Finally some sanity. As I mentioned yesterday it has been a peculiarity of Anglo-Saxon politics to be obsesses with encouraging people to buy their houses, irrespective of whether they can actually afford them or not.

Their logic is it creates a wealth effect (assuming prices go up of course) and encourages citizens as house-owners to be responsible members of society.

In practice of course it also encourages people to take on huge debts with minimal equity buffers in their property's value, and reduces their mobility due to the transaction costs and time-consuming nature of property transactions. It also encourages them to be totally irresponsible in the event of falling prices and simply walk away, leaving banks holding huge portfolios of defaulted property which they then have to dump onto a falling market.

The result was 2008's economic debacle.

Yet still politicians don't seem to get it. Two days ago Britain's David Cameron announced he would be using government funds to encourage building - increasing the supply of property at a time when house prices are falling, and to encourage higher borrowing among purchasers. This is almost a guaranteed disaster, and borderline criminal lunacy. Encouraging higher borrowing so people can get themselves "onto the housing ladder" when house prices are already falling, and at the same time increasing the supply of houses can only end in tears. And as ever, taxpayers will have to foot the bill when it all falls apart.

At least one person seems to get it though. "

Housing market 'unlikely to recover', says Bank of England expert"

Let's just hope someone pays attention.

So, here we are then....

I have finally had enough. The return of the crunch, which somehow seems to have surprised the current batch of politicians and economists was so easy to see coming that I can no longer take them seriously.

While supposed world leaders dither and prevaricate, and economists pontificate from their ivory towers, the world is slowly collapsing.

They seem incapable of grasping this. Politicians are lost in ideology, economists are lost in academia and theory. Neither seem able to grasp how things really work.

The very idea that shifting private sector debts to government balance sheets would somehow make everything better is farcical. Governments still have to service and repay their debts. Their only method of funding is taxation. Ultimately the private sector was always going to foot the bill, and always will.

The view that adding extra debt to the existing stockpiles will somehow make things better is nonsensical.

The problem started with too much debt at too low interest rates chasing too few assets. How is the solution more debt, at lower interest rates buying up falling assets?

How did all this start? A combination of factors none of which on its own would have caused such a big crisis but together made a toxic mix.

Central Bankers were fooled by China exporting deflation to the world for 10 years as their factories ramped up production and slashed manufacturing costs globally. As a result rates were held down in the face of benign inflation, and consumers, investors, and speculators were encouraged to load up with cheap debt. If this was used to fund true investment - building factories, paying for training courses or further education, creating infrastructure then it would have been great. In fact what happened is consumers loaded up on plasma TVs, holidays and cars they couldn't afford, investors just kept on buying anything they could creating a self-feeding circle driving assets ever higher in price, and speculators piled into all markets to drive things further, with particularly devastating consequences in the housing market.

Western governments also payed a large part. In many countries, particularly in what the French disparagingly refer to as the anglo-saxon sphere, governments actively encouraged home-ownership in the belief it would create a stable and prosperous society. They created tax breaks from the mildly generous - no capital gains on sale proceeds from primary home for example in the UK - to the insane - A$7,000 grant to first time buyers to pay their deposit in Australia. And all the while in the US, the so-called bastion of capitalism and supposed nemesis of socialism, the ultimate socialist model was upheld - almost every mortgage in America ended up being bought by the the two Government Agencies Fannie Mae and Freddie Mac, who funded those purchases by relying on the Government Agency status to issue AAA-rated debt into the bond markets. Effectively the US government guaranteed your mortgage. To make matters worse in the US, starting with the Clinton era banks were obliged or encouraged to lend to all borrowers at almost the same rate irrespective of their ability to repay. The government wanted poor people to enter the housing market, believing rising property prices would create wealth and help lift them up the socio-economic ladder. What they did was create subprime.

Banks didn't want to make these loans but were obliged to. Imagine their pleasure then when they found that incompetent rating agencies would allow them bundle up these piles of crap into bonds and rate them at the top level - AAA - the same as the Governments of Germany and the US. The banks couldn't believe their luck. The AAA rating meant that not only could they sell the mortgages to Fannie Mae and Freddie Mac but also to pension funds, bond funds, corporate treasurers, parish councils and individual investors. They could lend as much as they felt like, keep a margin for themselves and just turn round and flog the mortgages as a bond. Originally they kept no skin in the game. They just onsold and kept their own balance sheets clean. Then they started to believe their own propaganda. Asset and house prices kept climbing, mortgage bond spreads kept falling, inflation remained low so Central Bank rates were low and hence funding was cheap. They decided to start buying the bonds themselves. Just as it all fell apart. So much for the geniusses in bank risk and economic departments.

Then finally the circus stopped. House prices in particular reached a level which was simply no longer sustainable even with the "creative" mortgages being offered. House prices started to plateau. That was all it took. So much was bought on the assumption of selling it in a month or 2 at a profit that even a few flat months was a killer. mortgage costs were unserviceable, prices were no longer rising. The forced selling started and it all started to unravel. Banks and investors everywhere were suddenly holding worthless bonds and mortgages as the defaults started.

And all the prices moved together. When one started to fall, they all did, as they all held similar mortgages and no one had any idea what individual loans were behind the bonds they held. Panic spread fast. Banks stopped trusting their own assets, then they stopped trusting each other when each realised it was not alone in holding worthless crap. The interbank funding market, where banks lend surplus cash to each other for periods from a few hours to a few weeks, dried up. Then the final nail - the repo market dried up. This is the market in which banks lend to each other using bonds they own as collateral. The problem was their lenders no longer trusted either the quality of the bonds they were holding as that collateral, or even that it would be delivered in time from institutions which could go insolvent before the agreed deal has taken place.

That killed Lehman. And we all know what happened then.

So where are we now? In a mess. The private sector is sensibly trying to pay down it's debt, but this terrifies politicians as it inevitably means slow, no or even less than zero growth. Keynes famous paradox of thrift - individual saving is good, whole society saving is bad as it causes demand to fall. Politicians need ever stronger growth to get themselves re-elected so they are pulling out all the stops in an effort to get people spending.

The result is governments have spent three years pouring other people's money into sectors of the economy where they deem demand to be inadequate - think cash-for-clunkers car schemes for example.

Each time they do this they get a short-term boost, but all they are doing is pulling forward future demand so that once the boost fades the downside is worse than before. Think of having a Red Bull or double espresso - you get a short term boost but at the expense of feeling like crap later.

But they are addicted to handing out these shots because the alternative is to admit that there is going to be economic pain. That is political and electoral suicide.

So they continue trying to get economic activity "back on track" and to boost asset prices "back to pre-crisis levels" despite both being patently illusions created by turbo-charging normal economic activity with huge amounts of debt. And all the time they have been using money they don't have to provide these shots. Government debt levels have gone though the roof. Fortunately the bond markets are now calling them out on this and some sanity is returning as austerity budgets are belatedly pushed through, but still none will admit to the inevitable slowdown this will cause.

Only the US has escaped the austerity push, partly because of political deadlock, partly because the US$ is the world's reserve currency and as such is held by most major Central Banks as their largest currency pool. The result is continuing demand for US$ assets as a "safe-haven", but even the US can't run ever growing deficits and debt levels for ever. If the Government gets to grips with it, then it can be dealt with relatively easily. If the markets force it on them then it will be a mess that makes today look like a walk in the park.

In conjunction with this we have economic theorists as Central Bankers promoting Quantitive Easing as the solution. The idea is that by the Central bank buying government, mortgage and corporate bonds they will pump money into the system and hold down long term rates at the same time.

The problem is that when the private sector is scared and paying down debt, the velocity of money - the speed with which it moves through the economy - collapses. People, banks and corporates save the money not spend it. This can be seen everywhere. Individual saving rates are climbing, banks are placing huge deposits with Central Banks, not lending, and corporates are sitting on record cash piles.

So QE doesn't work. It didn't work any of the times it was tried in Japan, it didn't work in QE1, it hasn't worked in QE2 and it won't work in QE3.

I'm not sure how many times it has to not work before they will admit defeat but whatever the number is we don't seem to be close to it.

So where do we go from here? That's the interesting bit, and I look forward to finding out, and commenting on it.