Friday, June 15, 2012

Despite an increased risk of more defaults, there is light at the end of the Eurozone tunnel

Rising yields on Spanish and Italian bonds point to an increased likelihood of painful defaults, but declining swap spreads point to an eventual Eurozone recovery. Central banks are not stimulating, they are reacting, as they should, to intense demand for liquidity; that allows financial markets to continue functioning, and that in turn is a necessary condition for an eventual economic recovery.

These charts confirm the headlines: the Eurozone is still plagued with serious problems. 2-yr sovereign yields, a good barometer of near-term default risk, are quite elevated for the weaker PIIGS (Portugal, Ireland, Spain, and Italy). Ireland and Portugal have gone to the back burner since late last year, while Spain and Italy are now front and center; they are the biggest PIIGS debtors, with $3 trillion between the two of them.

Greece is a basket case, having already defaulted; the only question there is whether the Greeks this weekend will vote to leave the European Union and the Euro or not. Greece's decision by itself won't matter much to the world economy or to the financial markets, but if Greece decides to exit the euro—a decision that sounds easy on the surface, but spells great pain and suffering for most of the Greek population—then markets will worry that that will be the beginning of the end for the euro. I think a Greek exit from the euro, should it happen, might prove to be a wake-up call for the rest of Europe, since the consequences are impoverishment of the private sector via a wealth transfer to the public sector. The only one who stands to gain from a devaluation is the public sector. Everyone else will see their net worth decline significantly, their living standards eroded, and the return of inflation.

With a Greek vote—and its potentially dire consequences—imminent, with markets fearful that Eurozone defaults may reach many hundreds of billions of euros, with bank runs making headlines, and with recessions afflicting most of the PIIGS economies, it is very surprising—and encouraging—to see that Eurozone 2-yr swap spreads have fallen to their lowest level since last August. At 27 bps, U.S. 2-yr swap spreads are about as close to "normal" as one could hope. This can only be evidence that central banks are fulfilling their "lender of last resort" function. Europeans are desperately seeking safe havens (e.g., 2-yr Treasury yields of 0.3%, 10-yr Treasury yields of 1.6%, gold at $1625/oz., 5-yr TIPS real yields of -1.2%), and European bank stocks have lost fully 83% of their market cap since 2007, thanks to their huge exposure to PIIGS debt. If the ECB and the Fed weren't willing to inject massive amounts of liquidity to compensate for the almost insatiable demand for liquidity, the Eurozone by now would have been in the throes of a depression and deflation and most banks would have been wiped out.

So when I see the Bloomberg headline "Stocks Rise on Central Bank Stimulus Bets," I think the spin is completely wrong. By injecting liquidity through quantitative easing and near-zero short-term interest rates, central banks are not stimulating anything, they are reacting—as they should—to extreme levels of fear that threaten to drain liquidity and freeze financial markets. To the extent that equity prices are rising even as Eurozone conditions are dire and the U.S. economy is growing at a measly 2% rate, it is not because central banks are going to fix everything by dumping more money into the system, it is because central bank actions are preventing what could otherwise be a financial crisis from becoming an economic crisis. In other words, the S&P 500 is up because the U.S. economy is not collapsing, not because the economy is getting ready to take off. As I've argued for a very long time, markets have been priced to extremely pessimistic assumptions, which means that as long as we avoid a catastrophe, then prices have room to rise.

The decline in Eurozone swap spreads this year is thus a down payment on the eventual end of the Eurozone crisis, just as the decline in U.S. swap spreads in late 2008/early 2009 preceded the end of the U.S. recession by some 6 months.

By forestalling a liquidity shortage and financial market meltdown, central banks are establishing the necessary conditions for an eventual recovery. You can't have a recovery if financial markets collapse, but functioning financial markets can go a long way to helping an economy recover.

It's worth repeating what I said almost a year ago: the losses that result from PIIGS debt defaults have already occurred in an economic sense. Money was essentially flushed down the toilet the moment that Greece borrowed money to support the lifestyle of a bloated and unproductive public sector. Greece never used the money it borrowed for any productive purpose, and so it was eventually unable to repay its debt. It's as simple as that. Spain seems likely to default as well, but that's not as important as the fact that the losses from an eventual default occurred long ago when the money was first borrowed and then wasted on unproductive activities. What we are seeing now is the battle over who is going to have to take responsibility for these losses. The losses have already occurred; the other shoe that is yet to drop is whose balance sheet is going to have to take the hit. More PIIGS defaults are not going to create new economic weakness in the Eurozone, they are simply going to result in a transfer of wealth from those bearing the burden of the loss to the sovereigns being relieved of some or all of their debt burden.

The shareholders of Eurozone banks have already taken an enormous hit, probably absorbing the lion's share of the eventual losses. All Europeans are likely to share in the losses as well, to the extent that central bank liquidity injections result in a weaker Euro and higher inflation in the years to come. The Germans may get pressured to absorb some additional losses if keeping the euro and the Eurozone intact are important to them. Whatever the case, the losses are real and they are water under the bridge. By supplying enough liquidity to keep financial markets liquid, central banks are laying the groundwork for a resolution to the Eurozone crisis and forestalling what would otherwise be a depression/deflation of terrible proportions.


Bill said...

From an economist's point of view, do you think the US is in a period of Stagflation? It would seem the very low rate of GDP growth, flat to declining Capex, industrial production and employment all point to this conclusion, assuming you also believe inflation is accelerating or will accelerate in the near future.

Scott Grannis said...

I think it's premature to come to that conclusion. Economic growth is indeed weak, but it's not stagnant, and inflation remains well within acceptable bounds.

Bill said...

Regarding this weekend's vote, why is a vote for the leftists and refusal to follow the austerity agreement a decision to exit the Euro? I don't think there is a mechanism for throwing counties out of the Euro. They have to decide to leave. I would assume the IMF and other countries would cut Greece off but I don't think that means that they have to leave the Euro.

John said...


They would simply run out of money (euros). If Greece's govt refuses to abide by the march agreements there will be no more cash from Germany. The leftists are betting Germany will cave and give them the money anyway. IMO a bad bet. Polls show 60%+ of Germans think Greece should be out. My guess is Greece will form a pro euro gov't and things stay pretty much the same for now. Just my cheap opinion.

Hans said...

The omissions by the OPW, are nothing short of stunning...

Wrong one year ago, wrong today and wrong one year from now...

The ZombieZone, has gone from a crisis, to a collapse and as the great Uncle Milton predicated will end in tragedy...

Banks will require a trillion Euros and the EUB itself will require liquidity...

By now, one must ponder whether this union was even feasible in the first place, but then in the fertile mind of the left anything and everything is possible...

Thank you, Mr Grannis, for not practicing the art of censorship..

Pragmatic Investor said...

how do you know the problem with the European financial system is a liquidity problem, not a solvency problem? Do you know these banks are levered 20-30 times? A 5% drop in asset values will wipe out their equities.

William said...

Scott, thank you for your informed analysis. I truly appreciate the effort you make to keep us well informed.


Hans said...

PI, its both, liquidity which will lead to insolvency. Correct me if I am wrong.

Many governments are now insolvent and they will take the banking system down with them, as well.

A 70% reduction of debt to Grease was not good enough; even the complete forgiveness of debt will be insufficient, as Athens will demand a debt income credit.

Has now not come the time to ask if this amalgamation is doomed? The EU was created to have a single currency, one governing body and one Central Bank.

If Brussels had the ability to impose the necessary fiscal restrain needed to solve budget issues, then perhaps this union would work.

Not only is all politics local, so is spending..One union but 24 different budgets who's pols are more concerned about their electability than the health of the commonwealth.

This is no different if a bankrupt state (California comes to mind) simply applies to the WDC, for financial relief..Budget disciple is completely disregarded and the ongoing issues not addressed.

The only answer to this dilemma is a centralized control with arbitrary powers, something European nationalism would never allow.

As long as the cash flow was good, these deficiencies could be glossed over; now they are apparent to everyone.

The UK, Poland and Sweden clearly understood the inherit dangers of a monetary union; the Swiss, Norway (Noway) and Iceland wisely eschewed
the confederation.

The economic and monetary issues are not the only problems facing this continent; old rivalries, cultures, languages, races and ethics, furthermore, complicate this grand scheme...

The EU's lower tier states, which once benefited by a strong EURO, will now be hobbled by it...

As time pasts, more and more member states will realize that the liabilities out weigh the assets..

These problems are rooted in this collective system and may be reduced in scope, but if the EU survives these vectors will without a doubt manifest themselves again.

Hans said...

For what is its worth:

"The ever-articulate John Mauldin is reiterating his bearish take on the global economy in a new interview with King World News.
“What we’re seeing is the real end game” and “it is coming to an end,” he said.
According to Mauldin, Europe isn't solving its problems, but rather making things worse. Greece's "fundamental problem is its trade imbalance." And "Spain has lost access to the bond market. They can’t fund themselves."
"What we’re seeing is the real end game," says Mauldin. "We’re coming to the end of government’s ability to borrow money to fund current spending that’s beyond the growth of their economy."

Read more: