AND THIS WEEK A TURN FOR THE WORSE / PRUDENTBEAR.COM ( VERY HIGHLY RECOMMENDED READING )

And This Week a Turn for the Worse

by Doug Noland

June 01, 2012





Swiss two-year yields ended the week at negative 48 bps. Two-year yields were also negative in Denmark (-21 bps) and traded slightly negative for much of Friday’s trading session in Germany. Ten-year German bund yields closed the week at a record low 1.17%. Ten year Treasury yields dropped 11 bps today, pushing yields to a record low 1.46%. Long bond yields fell 12 bps today to a record low 2.52%. 


.
Today’s trading saw Gold jump $64. Spain Credit default swap (CDS) prices ended the session at a record 602 bps, up 258 bps from February lows. The Spain to bund 10-year yield spread widened 37 bps this week to a record 529 bps. Italian CDS surged 50 bps this week to 569 bps, nearing last December’s record high (582bps). 


.
Germany’s DAX index sank 3.4% today. Crude oil (July) dropped 3.8%, with a 3-day decline of 8.3%. The Goldman Sachs Commodities Index dropped 6.4% this week. For the week, the Russian ruble dropped 4.8%, the Brazilian real 2.6%, the Hungarian forint 2.4%, the Mexican peso 2.0%, the Czech koruna 2.3%, the Polish zloty 1.6%, and the South African rand 2.0%. Some market stress indicators remain significantly below 2008-type levels, while especially important indicators (including safehaven sovereign yields) have moved way beyond ‘08.




The bottom line is that the global financial system has again succumbed to crisis dynamics. And these days a powerful confluence of risk factors creates extraordinary systemic vulnerabilities. Europe and its faltering currency regime is a potential financial and economic calamity. A badly maladjusted global economy is slowing rapidly – which ensures unpleasant revelations. “Developing” economic and Credit systems are demonstrating fragility. The gigantic “global leveraged speculating community” is impaired and highly susceptible to faltering risk markets and the specter of illiquidity. And, importantly, there is the distinct possibility that global policymakers are losing control of the situation. I’ll attempt to briefly touch upon these factors one at a time.


.
First, Europe. If things went from “bad to worse” two weeks ago, they took a major “turn for the worse” this past week. Even European Central Bank (ECB) President Draghi this week questioned the sustainability of the euro structure: “That configuration that we had with us for 10 years which was considered sustainable has been shown to be unsustainable unless further steps are taken.” 


.
Alarmingly, fears of a disorderly Greek exit have seemingly been overtaken by a rapidly deteriorating situation in Spain. At about $1.5 TN, Spain’s economy is generally ranked the 12th largest globally. The country’s GDP is about double the size of Greece, Ireland and Portugal combined. It is a “core” European economy – and the harsh reality is that this cancerous debt crisis at Europe’s periphery has now afflicted the system’s weakened core. 



.
The Bank of Spain reported yesterday that 100bn euros had exited the country during the first quarter. One is left fearing the scope of outflows during April, May and now June. It is worth noting that the spread between Spain and German 10-year yields widened 37 this week to a record 509 bps – with today the fourth consecutive session where the spread traded wider than 500 bps. The Financial Times this week noted that Greek debt traded wider than 500 bps for 16 days before it required a bailout, while it took 24 days for Ireland and 34 days for Portugal.




Market confidence in both Spain’s banking system and its indebted regional governments has evaporated. While I generally sympathize with post-Bubble policymakers, Spain’s leadership is now viewed as ineffective and inept. They have dragged their feet in the face of an acutely unaccommodating financial environment. The Spanish government remains unable to provide a viable plan for recapitalizing its crumbling banking system or for backstopping distressed borrowers from Spain’s regional governments. With finance now fleeing the country (Greece, euro and domestic fears), the economy in a tailspin, and market access now effectively closing, Spanish government finances have hit the wall. And it’s an especially inopportune time to hit a funding wall, whether you’re a highly indebted bank, a government unit, a corporation or leveraged speculator.



.
Spain has called for the ECB to buy its debt and for the EFSF/ESM (European Financial Stability Facility/European Stability Mechanism) to help finance bank recapitalization. Both requests are viewed as significantly beyond respective organizational mandates. Essentially, Madrid has been playing high-stakes poker – yet bluffing is a risky strategy when you’re about out of chips and beads of sweat are dripping from your forehead.




It’s now abundantly clear that Spain is facing much worse than liquidity issues; questions of solvency abound – the banks, the regional governments, and a sovereign trying desperately to hold things together. So the ECB will resist monetizing additional Spanish borrowings. And the rules of engagement for Europe’s fledgling sovereign “firewall” lending facilities (EFSF&ESM) forbid lending directly to banks. 



So the view of German and other policymakers will be that if Spain requires a bailout, the International Monetary Fund and the EFSF/ESM will play predominant roles in supporting the Spanish sovereign. Spain’s leaders, especially after having witnessed the plights of Greece, Ireland and Portugal, have been determined to avoid relinquishing national sovereignty. Meanwhile, the scope of Spain’s potential borrowing needs sets off alarm bells for the emergency lenders and the marketplace more generally.




Today’s weak U.S. payroll data throws gas on a fire. Inarguably, economic data for the week had already strongly supported the view of a rapidly slowing global economy. European data was more of the abysmal. The Italian jobless rate jumped to the highest level in 12 years (10.2%), while contagion effects push the UK economy back into recession. Yet these economies appear robust when compared to Greece and Spain. 


.
Perhaps more alarming, news from the developing world has turned sour. There was more weak manufacturing and housing data out of China, as Asian economic indicators almost universally point toward a synchronized regional slowdown. India’s GDP sank to a nine-year low, with Q1’s 5.3% growth down from Q4’s 6.1% and Q1 2011's 9.2%. Reporting on Brazil’s slight (0.2%) Q1 GDP expansion, Bloomberg’s headline was spot on: “Weaker Brazil Economy Raises Doubts About Credit-Led Growth.” There is increasing evidence of a dramatic tightening of financial conditions throughout the emerging markets, a harbinger of buffeting economic headwinds.



.
It will take some time for performance numbers to begin trickling in. There will undoubtedly be major carnage reported throughout the hedge fund and leveraged speculator community. Global stock prices have been hammered; emerging debt, equities and currencies have been under pressure; global Credit spreads have widened dramatically; crude and many commodities prices have tanked; and risk markets in general have faltered in unison. 



.
For players with a portfolio of diversified bets among various asset classes, recent performance has been a stark reminder of how quickly disparate markets can all turn highly correlated. Those positioned for “risk on” have been bloodied. I’ll assume virtually everyone has been compelled to begin reducing risk exposures, as de-risking/de-leveraging dynamics take full control. 




Markets turned increasingly disorderly to end the week. Of course, market participants have become conditioned to anticipate a policy response. Market professionals will be monitoring their screens attentively Sunday evening. Yet it’s an extraordinarily high-risk environment for policymakers.


.
They’ve intervened too often, too predictably and too obtrusively. The markets will now quickly lose patience if major policy support measures are not immediately forthcoming. At the same time, policymakers surely appreciate the serious predicament they face if markets sell on the policy news. 


.
Hence, to more than momentarily jam global risk markets will require a significant and coordinated policy response. And it must be more than simply announcing global central bank liquidity assurances and dollar swap lending facilities. European leaders must demonstrate that they can come to some agreement on a comprehensive and credible stabilization plan. This is clearly anything but a slam dunk.



.
It is an exceptionally troubling backdrop. I have always feared the day when reflationary policy measures finally wouldn’t suffice. 


.
I’ve worried that the leveraged speculators would eventually blow up – a dynamic I expect to occur concurrently with policy measure impotence. I’ve feared derivative and counterparty problems that, yes, would occur concurrently with hedge fund and market illiquidity issues. In short, I’ve always worried about a global crisis of confidence with respect to the contemporary “global financial infrastructure.”



.
I don’t claim to have a good feel for how far we might be from such a critical juncture. I do know that extremely serious issues have been met with incredible complacency. I see no reason for confidence in the capacity for policymakers’ to grasp what is developing. There are reasons to question the efficacy of policy measures. I fear there are latent global financial and economic fragilities of an extraordinary nature. And I am confident that what is unfolding has the potential to be more problematic than 2008.