THE EU MUST FOLLOW U.S.´S QE2 WITH SHOCK AND AWE 2 / SEEKING ALPHA ( HIGHLY RECOMMENDED READING )

The EU Must Follow U.S.'s QE2 With Shock and Awe 2

by: Cliff Wachtel

November 14, 2010  

Prior And Coming Week Market Drivers

Everyone knew the EU Sovereign Debt And Banking Crisis would return, it was only a matter of when and how. No we know. If Act I was Greece, Act II is Ireland. Next week’s trends depend largely on how the EU responds to market fears about Ireland and other PIIGS on the brink. If markets can be calmed, they could recover from the nascent downtrend. If not, much more downside risk remains. So what must be done? Before we look at the prior and coming week key market drivers, let's cut to the key lessons from the prior Greek crisis and see what last week's events bring to mind.

If you understnd these, then you'll be a step ahead of the others in anticipating the coming week's trends depending on how the key EU players behave.

The most important lesson from Act I was the importance of decisive action to quickly calm markets and regain confidence. That means not only quickly but comprehensively, with a rescue plan that not only deals with the immediate crisis but the ones that markets anticipate will quickly follow if not addressed right away.

With Greece, the EU kept offering plans that were too small to address even Greece’s immediate needs, never mind those of any other PIIGS nation in trouble that could soon see its bonds being shorted and yields soaring to levels that would make default a mere matter of time. Even if EU leaders attempt a rapid rescue plan to calm markets, it will fail if it focuses only on Ireland.

As with the Greek crisis, markets won’t calm down unless there is a plan to deal with the next foreseeable crises as well.

Otherwise, bond markets will fear that bond vigilantes will just move on to driving up Portuguese or Spanish debt.

Anything less than a large ‘Shock And Awe’ risks resulting in another ‘Shock And Awwww…’ that fails to ease PIIGS borrowing costs.

In sum, unless there is a comprehensive plan to deal with all PIIGS default risk, expect risk assets to struggle, especially the EUR.

PAST WEEK

With US stimulus an old story and a quiet news week, markets were ripe for new developments from our weekly wildcards, the global trouble spots we KNOW will produce volatility we just don’t know quite when.

These are:

• The EU Sovereign Debt And Banking Crisis
• The US Real Estate and Banking Crises
• 1. Part I: Subprime Lending and Coming Mortgage Resets
  2. Part II: Foreclosure Fraud Liabilities Both Civil and Criminal
• China Slowdown Or Bubble Burst

This past week numbers 1 and 3 were THE market movers and appear poised to continue their influence into next week.

EU SOVEREIGN DEBT AND BANKING CRISIS ACT II: IRELAND

Bond markets, as reflected in spiking Irish and other PIIGS bond yields, had been aware of the problem for weeks.

Forex markets were already picking up the problem late last week as reflected in the sharp reversal of the EURUSD.

Note the EURUSD chart below began a clear retreat Friday Nov. 5^th.

EURUSD DAILY CHART 05 NOV 13 H

Here’s how the EU Crisis stepped back into focus for the broader global markets.

• It began with Monday’s now famous Irish Times article by Irish economist Morgan Kelly, which described Ireland’s dire fiscal situation in all its morbid detail.

• The story then was picked up by the WSJ Tuesday, quickly spread to the rest of the mainstream financial press and blogosphere, and Act II of EU Sovereign Debt and Banking Crisis, Ireland, was born.

Note the moderate decline in risk appetite on Monday depicted on the S&P 500 chart below, became both much more volatile and pronounced Tuesday Nov 9^th, as the IT story from Monday hit the WSJ and the rest of the mainstream press and blogosphere.

S&P 500 DAILY CHART 04nov13

Irish bond yields had been rising for weeks and had not prevented the EUR’s marching higher, primarily due to USD weakness from coming US stimulus. Yet between Monday and Tuesday the recognition of Ireland’s dire condition shifted broad market sentiment firmly against the EUR and risk appetite as depicted in global equities on a combination of:

• the US stimulus /USD weakness story becoming a bit old and fully priced into the heavily oversold USD and overbought EUR
• these 2 key articles coming out on quiet news days

Stocks and risk currencies lost ground most of the week. Commodities held on better, not surprising given their status as currency hedges. Precious metals and oil held on especially well. However virtually all risk assets fell steeply on Friday.

AGAIN, there has been no fundamental improvement in the EU crisis, merely a delay in the day of reckoning. Indeed it is only getting worse as:

• Ireland joins Greece as the second basket case economy that it too sick to recover without lots of aid via EUR printing. 
• The pain of austerity plans begins to sink in, sparking deteriorating GDP in Greece, social unrest in Greece, Spain, France and the UK. This in turn casts doubt on whether the EZ can in fact sustain the planned austerity and whether the EU/IMF aid package, which is contingent on austerity plans, survives.
• All the problems remain. The PIIGS are not able to grow fast enough to reduce their debt/GDP, and in Greece and Ireland this is getting worse, casting doubt on the effectiveness of austerity. ECB just threw money at Greece to buy time in hopes that a global recovery would help Greece turn around. Instead the delay is simply allowing confidence in the EU to slide further.

The big questions are:

• how long can the ECB keep buying PIIGS bonds & prevent 1st PIIGS domino from falling?
• whether global leaders have learned the lessons of 2010 with Greece, that given the systemic risks they WILL in the end print up some cash and bail out even small nations like Greece and Ireland and whoever else needs it, in order to prevent another banking and market collapse?

The good news is the lesson may well have been learned, particularly by those who needed it most, the Germans. Unlike early this year, German officials have been quick to back away from tough talk about making Irish bond holders bear losses and imposing sanctions on nations that don’t comply with budget requirements.

Thus it’s possible we’ll hear about a bailout, bond guarantee, or other plan to calm markets as early as this week. It appears understood that the global economies are like cliff-climbers all tied together by a rope. Once one or two fall, the rest risk being dragged into the abyss as well.

Yes, there is definitely a problem of moral hazard developing as bond buyers and governments may begin to assume no bond defaults will be allowed in the EZ.

CHINA COOLING

Lower than expected Chinese industrial and retail data along with higher than expected inflation provided a secondary shock to risk appetite. China growth remains robust and thus this data, unlike the EU Crisis resurfacing in Ireland, lacked the potential to send markets crashing. However China remains the primary growth engine and is a key importer of commodities and thus driver of prices for the AUD, NZD, and CAD.

BOE INFLATION REPORT INDICATES NO STIMULUS COMING, BOOSTS GBP

The GBP was the second strongest currency this past week, mostly on the hawkish BoE Inflation Report, which told markets no new stimulus was coming until next year at earliest.

CISCO DOWNSIDE GUIDANCE

As reported by briefing.com:

Shares of Cisco plunged -17.0%, acting as the main drag this week. The company posted better-than-expected fiscal first quarter earnings per share, but issued downside guidance for the second quarter and fiscal year. Cisco expects second quarter revenues to be up 3-5% and fiscal year revenues to be up 9-12%. Those forecasts are below current Thomson Reuters consensus estimates that call for growth of 12.8% and 13.1%, respectively. The company is keeping a conservative outlook due to slow public sector spending.

COMING WEEK LIKELY MARKET MOVERS

BARRING A NEW RESCUE PLAN FOR IRELAND, CONTINUED EZ UNCERTAINTY WEIGHING ON RISK APPETITE

The yields on PIIGS debt, especially for Ireland, have been climbing steadily since EU leaders agreed to consider German Chancellor Angela Merkel’s proposal for a permanent rescue mechanism that involves restructuring with losses for private holders of sovereign debt as opposed to losses being transferred to the tax payer.

The EUR/USD fell about -2.5% this past week as sovereign debt concerns mounted. The blowout in peripheral yields contributed to a declining EUR as Irish and Portuguese 10-year yields reached record high levels at 8.896% and 7.036% respectively.

As noted above, Germany has backed away from these statements in an effort to avoid once again panicking markets like they did during the last Greek crisis with misplaced calls for discipline after Greece was beyond the point of recovery without aid. Even if a rescue plan comes, there remains significant risk of more downside for risk assets and the EUR.

Specifically, focus could then shift to Portugal and possibly Spain (which will be of great concern given that Spain represents about 11.5% of EZ GDP compared to Ireland’s 1.7% share of EZ GDP).

The key question then is whether EU leaders will come up with a plan that deals not just with Ireland but also the risks of other sovereign defaults.

WILDCARDS TO WATCH

• EU SOV. DEBT/BANKING CRISIS: To continue barring a rescue not just for Ireland but for all PIIGS at risk of trouble in the near future

• China Slowdown Evidence

• US BANKING/ RE CRISIS

a) Part I: The continuation of the old one:

I. banks have yet to purge existing bad loans, still recovering from those

II. RE prices both commercial and residential falling, bringing further deterioration to bank loan portfolios as strategic and other defaults grow

III. Mortgages due to reset over coming year to bring more foreclosures in new numbers

b) Part II: Foreclosure fraud – total damage estimates vary widely from tens to hundreds of billions in mere legal liability for selling mortgage securities without good title to the underlying property and knowingly doing so or falsifying title, before damage to housing market from possible slowdown in foreclosure sales also hurts banks.

CONCLUSIONS

If there is progress towards a quick and comprehensive rescue for Ireland, Portugal, and other PIIGS at risk, expect risk assets to recover, especially the EUR, with corresponding pullback in the USD. Precious metals and other commodities in their role as currency hedges, would be pulled by opposing forces. Dragged down by calm about the EUR, but supported by USD weakness.