15th Nov - Credit Guest: Squaring the Circle

A cross-post by Macronomics.

Credit - Squaring the Circle

"Evolution has long been the target of illogical arguments that use presumption." - Marilyn vos Savant 

While listening to Olli Rehn's recent comment relating to Greece, and seeing France's latest rating cut to AA, with aggravating industrial production pointing to a weaker GDP going forward, we reminded ourselves of the famous problem proposed by ancient geometers for this week's chosen title namely "Squaring the Circle".

“I’m sure that we will be able to find a satisfactory solution as regards to how to ensure the fiscal gaps will be filled and the fiscal targets will be met.” - Olli Rehn

The different steps taken to resolve the inadequacies of the euro have been strikingly similar with the problem proposed by ancient geometers, namely "Squaring the Circle" being the challenge of constructing a square with the same area as a given circle by using only a finite number of steps with compass and straightedge.

Although in 1882, the task was proven to be impossible, as a consequence of the Lindemann-Weierstrass theorem proving that pi is transcendental, rather than an algebraic irrational number, it did not prevent an amateur eccentric crank by the name of Dr. Edwin J. Goodwin to try to brace mathematical immortality by trying to have the legislature in Indiana in 1897 to redefine the value of pi through House Bill 246! We kid you not. It would have enabled the brave Dr Goodwin to solve the aforementioned problem of "squaring the circle".

In similar fashion to the brave Dr Goodwin, our European politicians such as Olli Rehn are trying to finalize the construction of the Euro through a "finite number of steps", and on that note we think about the upcoming AQR (Asset Quality Review) and the willingness of European politicians to secure the creation of a European Banking Union, through legislature.

By that point you are probably asking yourselves where we are going with all this but, our fondness for behavioral psychology reacquainted us with one of our past quote following our "Generous Gambler" aka Mario Draghi latest rate cut stunt:

"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

In this week's conversation we will focus our attention once more on Europe and the impossibility of "Squaring the Circle" even through European Banking Union.

Our European "deceiver in chief" has pointed out the improving credit conditions in the money multiplier - graph source Bloomberg:

"ECB President Mario Draghi noted in comments following a rate cut that euro zone fragmentation had been improving from mid-2012, though progress halted three to four months ago. This echoes a north-south divide in wholesale bank funding costs that has again widened. Further, the money multiplier demonstrates how the flow of credit had begun to improve from mid-2012. September's 7.7x figure is the first month in a year that the multiplier has contracted." - source Bloomberg.

The issue of course is that, given the pending AQR, the Euro zone contraction in excess liquidity could no doubt counter the wishes of our European "generous gamblers" we think - graph source Bloomberg:

"Excess liquidity in the euro zone bank system is considered tight when below 200 billion euros ($267 billion) and a sustained period below this level has driven interbank rate increases in prior cycles. Even as the ECB has cut its main refinancing rate, which may lead to a steeper yield curve and income boost for some banks, an increase in wholesale funding costs could offset this. Euro zone excess liquidity may also fall as banks withdraw ECB deposits to reduce leverage."  - source Bloomberg.

Arguably what has been most beneficial as of late for European exporters has indeed been the proverbial "sucker punch" delivered by the surprise rate cut by the ECB on Thursday to 0.25% on the Euro currency versus the US dollar - graph source Bloomberg:

But, we have long argued that the previous LTROs amounted to "Money for Nothing". The latest round of "generosity" courtesy of the rate cut by the ECB will only favor more of the same, namely more carry trades for peripheral banks which have been gorging themselves with government bonds from their respective countries with the help of the two previous LTROs as displayed by the below Bloomberg table:

"A fringe benefit from today's ECB rate cut, beyond signaling an aggressive stance and longer-term low-rate environment, may be a steepening of the yield curve. Regionally, at 10.2% of bank-system assets, Italian banks have the greatest sovereign-bond exposures with 422 billion euros ($564 billion). They are followed by Spanish lenders at 312 billion euros (9.5% of assets) as at the end of September. Any steepening may benefit interest income." - source Bloomberg.

So we think that the willingness through "legislature" in severing the link between European sovereigns and their respective financial institutions amounts to "Squaring the Circle" in true Dr Goodwin fashion hence the path for this week's chosen title.

Throughout our numerous conversations, we have argued about the deflationary forces at play and the raging battle attempted by central bankers to ward off the threat of deflation. It is a losing battle we think when one looks at the crumbling inflation in Europe as displayed by Bloomberg Chart of the Day from the 6th of November:

"The CHART OF THE DAY shows the five-year consumer-price swap rate declined to 1.34 percent on Nov. 1. That’s within one basis point, or 0.01 percentage point, of the level reached in June last year, which was the lowest since December 2008 and was followed by a 25-basis point reduction in the ECB’s main refinancing rate the following month. Reports today showed euro-area services output rose in October and German factory orders increased in September. “Despite the recovery, there’s still a lot of slack in the euro-zone economy,” said David Mackie, chief European economist at JPMorgan Chase & Co. in London. “If the ECB doesn’t respond to falling prices, people will worry about its commitment to meeting its medium-term objectives. The risk is that inflation expectations will fall further and create problems for them.”" - source Bloomberg.

For those who have been following us, you know that like any good cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content. As we indicated in our conversation "The Dunning-Kruger effect": 

Not only do our central bankers suffer from the Dunning-Kruger effect but they are no doubt victim of the well documented "optimism bias" which we discussed in our "Bayesian Thoughts" conversation:

"Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, we underrate our chances of getting divorced, being in a car accident, or suffering from cancer. We also expect to live longer than objective measures would warrant, overestimate our success in the job market, and believe that our children will be especially talented. This phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics."

Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

When it comes to "optimism bias", the surprised rate cut by the ECB was indeed a proper demonstration given only 3 out of 70 economists had predicted a rate cut of 0.25% on Thursday but we ramble again...

After all, one only need to look at the German 2 year yield to realize that credit wise Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation which is what we are seeing in Europe and what a 0.7% inflation rate is telling you hence the ECB rate cut this week. It is still the "D" world (Deflation - Deleveraging).

As pointed out previously by our friend Martin Sibileau (who used to blog on "A View From The Trenches"), here is a reminder from his work which we quoted in our conversation "The law of unintended consequences" in Macronomics on the 25th of January 2012:

"With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance."  - Martin Sibileau

Europe's horrible circularity case - Martin Sibileau

By tying itself to Europe via swap lines, the FED has increased its credit risk and exposure to Europe:
"If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU." - Martin Sibileau

As a side note and in relation to the EU private sector seeking USD funding as displayed in Martin's chart above, in 2012 over a third of the US Investment Grade supply (net issuance in $430 billions) was from non-US issuers up from 25% in 2011. This year we have seen about a third of the new issuance from non-domestic issuers (estimated net issuance for 2013 $400 billions).

As we have argued in "Mutiny on the Euro Bounty" in April 2012:

"More downgrades mean more margin calls, more margin calls means more liquidation and more Euros being bought and dollars being sold, with a growing shortage of AAA assets, Europe is moving towards mutiny on the Euro Bounty ship..."

Unless of course Mario Draghi goes for the nuclear option, Quantitative Easing, that is.

And as indicated by Martin Sibileau from his note from the 17th of October "The EU must not recapitalize banks":

"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

When it comes to the growth divergence between the United States and Europe ("Growth divergence between US and Europe? It's the credit conditions stupid...", it is all about Stocks versus Flows. We posited the following in various conversations:

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

As the ECB approaches the zero bound boundary in its "easing" process, the only tools left will of course will have to be "unconventional" as pointed out in our conversation "Fears for Tears" in August:

"Should Mario Draghi feel the urge to trigger is "nuclear" device, it will have to be "Brighter than a Thousand Suns", to quote, J. Robert Oppenheimer...

Oh well..."

The interesting issue as of late when it comes to the AQR and banks recapitalization in Europe is that Germany firmly opposes the use of the ESM for that specific purpose. Excluding the ESM from financing the winding down of troubled banks will raise the problem of a financial backstop for the SRM (Single Resolution Mechanism), possibly delaying its proper operation for years, which from our point of view is interesting as we think that Germany in the end will be the country putting the nail in the coffin for the Euro experience as we indicated in our conversation "Eastern promises" on the 9th of June:

"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

Squaring the Circle cannot be solved and the vicious cycle of banks and sovereigns cannot be solved either by a European Banking Union on its own.

Angela Merkel in this "Game of Century", while only appearing to be making material sacrifices, has managed to keep most of Germany's liabilities unchanged. So delaying the proper operational prospects for the SRM is in fact the application of what we said in our Chess analogy used in our "Game of Century" conversation in July 2012:

"In respect to the recent European summit, if European countries such as Italy, Spain and France gang up on Germany and ask for material changes in the rules and treaties of the "chess game" being played, we believe that "the only possible Nash equilibrium for Germany will be to defect""

Interestingly, Ambrose Evans-Pritchard from the Telegraph, in his article from the 4th of November entitled "Italy's Mr Euro urges Latin Front, warns Germany won't sell another Mercedes in Europe" reported on possibility of "Mutiny on the Euro Bounty":

"The plot is thickening fast in Italy. Romano Prodi – Mr Euro himself – is calling for a Latin Front to rise up against Germany and force through a reflation policy before the whole experiment of monetary union spins out of control.

"France, Italy, and Spain should together pound their fists on the table, but they are not doing so because they delude themselves that they can go it alone," he told Quotidiano Nazionale

Should Germany persist in imposing its contractionary ruin on Europe – "should the euro break apart, with one exchange rate in the North and one in the South", as he puts it – Germany itself will reap as it has sown. "Their exchange rate will double and they will not sell a single Mercedes in Europe. German industrialists know this but all they manage to secure are slight changes, not enough to end the crisis."" - source The Telegraph.

As a matter of fact funding for the ESM is capped at 700 billion euros and Germany is responsible for contributing about EUR190 billion by next April to the program but there is a snag. While the German Constitutional court has no legal authority on the ECB, it does have authority over the German parliament when it comes to committing German money to European programs (ESM and OMT included) given a debt of the ESM is a contingent liability of all the non-bailed out Eurozone countries.

As far the "optimism bias is concerned, a majority of analysts believe the German Constitutional court will allow the OMT to stand on the basis that EU treaty allows for purchases in the secondary bond market. We beg to differ. 

Once a debt is a contingent liability, for instance "super senior" there is no turning back, but the ESM being capped and the OMT yet to be firmly backed by Germany, the nuclear option is still an option rather than a reality.

We quoted Dr Jochen Felsenheimer in our conversation "The Unbearable Lightness of Credit" in August 2012, let us do it again for the purpose of the demonstration:

"The advantage of explicit guarantees is that the market can value them and that the guarantee can be taken up - even in a crisis! For this reason, we can quote the "last man standing" at this point, the president of the German Federal Constitutional Court, Andreas Vosskuhle:"The constitution also applies during the crisis". That is a hard guarantee, both for politicians and for investors!"

We will not discuss the issue of implicit guarantees and explicit guarantees from a credit valuation point of view as we have already approached this subject in our conversation quoted above. The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them. Obviously our great poker player "Mario Draghi" at the helm of the ECB has played with his OMT a great hand but based only on "implicit guarantee". That's a big difference.

An illustration on how distorted market can become when taking advantage of "explicit guarantees" has been the European car industry. We have extensively covered the subject as an illustration of the deflationary forces at play back in April 2012 in our conversation "The European Clunker - European car sales, a clear indicator of deflation" for those of you who would like to go deeper into the analysis. More recently, the effect of the latest Spanish Cash-for-Clunkers to support 70,000 new cars is illustrative of "explicit guarantees" we think as pointed out in the Bloomberg table below:

"Spain plans to support 70,000 new-car purchases under the fourth cash-for-clunkers scheme it has introduced in a year. Buyers will get 2,000 euros ($2,700), evenly funded by the government and dealer, when trading in a car between seven and 10 years old, and buying a new, more fuel-efficient vehicle costing up to 25,000 euros. Spanish auto sales through September were 51% below the average for the same period in 2000-07." - source Bloomberg.

Markets being extremely feeble creatures in the face of uncertainty will obviously react "rationally" when it comes to being provided with "explicit guarantees".

Obviously the lack of German Constitutional support could indeed prevent the whole "whatever it takes" European moment from moving from the "implicit guarantees" towards more "explicit guarantees" we would argue.

As pointed out by Bloomberg editors in their column from the 6th of November 2013 entitled "Europe's unfinished business threatens another recession",the European Banking Union is a must have. For us Europe is just trying to "Square the Circle:

"The most important stalled reform is in banking. Another round of bank “stress tests” has just been announced -- and this time, the ECB says, it’s serious. But there’s still no agreement on what happens to the banks that fail the tests. It’s universally agreed that the euro area needs not just a single bank supervisor -- which it now has in the form of the ECB --but also a single bank-resolution mechanism. That won’t fly, because Germany and like-minded countries won’t hear of bailing out failing banks or their financially stressed national governments.

This reluctance is understandable. But without a single bank-resolution mechanism, the euro project remains fatally flawed. The toxic link between distressed banks and distressed governments will remain. So long as that’s true, recovery will be held back and the euro area’s supposedly integrated capital market will be at risk of further splintering into separate zones. If the euro is to survive and its member countries prosper, a real banking union is indispensable." - source Bloomberg

The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe.

On a final note, and in relation to "markets" going forward, in our conversation "The Cantillon Effects", we indicated of one of our "outside the box indicator" namely Sotheby's stock price versus world PMIs since 2007 - graph source Bloomberg:

We have argued that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months.

It was interesting to see Sotheby’s stock price being down as much as 4% on the 6th of November, most intraday since Aug. 7, to lowest since Oct. 15, on 71% avg 3-mo. vol. as other auction house Christies flopped for a second consecutive night on the 6th of November in New-York with top-priced lots by Picasso, Modigliani and Leger failing to find buyers as reported by Bloomberg by Katia Kazakina and Philipp Boroff:

"Last night’s sale “also suffered from overestimation on several of the top lots,” said art adviser Mary Hoeveler. “Buyers don’t need to be told when something is a ‘masterpiece.’”

Alberto Giacometti’s portrait of his brother Diego, estimated at $30 million to $50 million, didn’t attract a bid in the room or on phone banks.

The painting was guaranteed by an undisclosed third party before the sale and the guarantor took it home for $32.6 million, a record for a Giacometti painting. Prices include commissions. Estimates do not.

The 1954 piece was sold by Jeffrey Loria, an art dealer and owner of the Miami Marlins baseball team, according to a state regulatory filing." - source Bloomberg.

So there you go the "explicit guarantee" did indeed lead to a sale in the end for Giacometti's portrait of his brother Diego, but we would not call this a "functioning market", somewhere, somehow someone took a hit.

As pointed out by our friend Cameron Weber in our conversation  "The Cantillon Effects", using art as a reference market in describing Cantillon effects and asset bubbles if of great interest as per his presentation entitled "Cantillon effects in the market for art":

"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.

This is as well confirmed by our good friends at Rcube Global Macro Asset Management in their recent monthly review:

"The Art market has always been an interesting indicator. The only major public auction house is Sotheby's since its floatation in the mid-1980s. It has proved a timely indicator of potential global stock markets reversal.

Whenever its price reached 50 or so with sky high valuations, a reversal was not far away. We can also take notice of the extremely weak jewelry and contemporary art auctions recently."

"To acquire knowledge, one must study; but to acquire wisdom, one must observe." - Marilyn vos Savant, American writer

Stay tuned!