Financial fragmentation across the Eurozone can not be ended by extending ECB credit to periphery governments

Resolving the issue of broken monetary transmission (discussed here) in the Eurozone will take more than buying periphery government bonds. David Powell from Bloomberg used the Taylor Rule to determine policy rates that would be appropriate for the various nations as well as the Eurozone as a whole. The concept was first described by the San Francisco Fed:

FRBSF: - The Taylor rule is a policy guideline that generates recommendations for a monetary authority’s interest rate response to the paths of inflation and economic activity (Taylor 1993). According to one version of this rule, policy interest rates should respond to deviations of inflation from its target and unemployment from its natural rate (Rudebusch 2010). A simple version of this rule is:

Target rate = 1 + 1.5 x Inflation – 1 x Unemployment gap.

The target rate recommended by the rule is a function of the inflation rate and the unemployment gap. That gap is defined as the difference between the measured unemployment rate and the natural rate, that is, the unemployment rate that would cause inflation neither to decelerate nor accelerate. The literature shows that this simple rule or close variations approximate fairly well the policy performance of several major central banks in recent years (see Taylor 1993 and Peersman and Smets 1999).

The current ECB policy rate turns out to be right on target (in agreement with the Taylor rule) for the Eurozone as a whole, but the policy rates diverge wildly across the euro area countries.

Bloomberg: - A Taylor Rule demonstrates the drastically different monetary policies required in those countries as a result of their domestic economic conditions. The model, based on coefficients estimated by the Federal Reserve Bank of San Francisco, signals the main policy rate should be minus 7.75 percent for Spain. It should be minus 3.75 percent for Portugal, minus 3.5 percent for Ireland and minus 10 percent for Greece. Germany is at the other end of the spectrum. It requires a main policy rate of 4.25 percent.

Source: Bloomberg

And as discussed here, this divergence made depositors question the sustainability of the euro due to potential re-denomination risks (in addition to bank solvency) and encouraged them to move funds out of Spain. Similar trends are taking place in other periphery nations.

Bloomberg: - Those economic divergences appear to have led depositors to question the sustainability of the monetary union in the absence of large-scale fiscal transfers to cushion the weakness in certain countries. In Spain, the level of deposits from non-monetary and financial institutions, excluding government, declined by 74.2 billion euros in July, a record large drop, according to monthly data from the ECB. The year-over-year rate of growth stood at minus 10.9 percent.

ECB's asset purchases are unlikely to convince depositors to reverse this trend of capital flight. What's more, many Eurozone periphery citizens will continue to move deposits out of the Eurozone altogether. These euros will then be "trapped" as part of the foreign reserve accounts of the Swiss National Bank (discussed here) and Danmark's Nationalbank (discussed here).

Bloomberg: - Draghi will probably have to convince market participants of the economic sustainability of the monetary union before the financial fragmentation of the region is ended. The large-scale extension of central bank credit to potentially insolvent countries is unlikely to accomplish that.

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Fed's unemployment target is unrealistic

The Fed's goals for the US longer term unemployment levels are simply unrealistic and will force the central bank to prolong its easing programs beyond what is really needed for economic growth. This misguided approach will be damaging to the economic growth in years to come.  Here is what the FOMC is projecting for the "longer run" unemployment - a rate that is in the 5%-6% range.

Source: Credit Suisse

As discussed in this post, the Beveridge curve clearly shows that the US had a structural shift in employment dynamics after the financial crisis. What was considered the "equilibrium" unemployment (also called "natural" unemployment) rate needs to be adjusted upward. A more realistic unemployment goal should be in the 6%-7% range, a much more achievable target.

Robert Gordon from Northwestern (via Market Watch): -  “I think more realistically that, gradually, [unemployment] equilibrium will move from 5% to 7%,” he said. He says that fits with anecdotes of businesses finding difficulty in hiring workers with the right skills, and with skills eroding from the long-term unemployed.

When Ben Bernanke referred to current unemployment picture (at Jackson Hole) as "a grave concern" that causes great suffering, he was right. But unfortunately that is the "new normal" and the Fed simply won't be able to push the unemployment rate materially lower than this new equilibrium level. However it may end up doing a great deal of damage while trying.

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Bank of Spain providing emergency loans to Spanish banks; pressure mounts on the ECB

Despite the ECB's rhetoric on defending the euro that pushed up global risk asset valuations, the underlying issues of the Eurozone have not been resolved. Signs of the run on Spain's banks are once again in the press. Previously we had Der Spiegel describe the enormous euro deposit outflows from the Spanish banking system (see post). The problem has not gone away and here is an update with some explanations (in italic).

WSJ: - The latest trouble is the inability of Spanish banks to finance themselves through usual means. Capital markets remain largely shut because investors refuse to buy bank bonds at affordable prices. And customers, nervous about the banks' health, are increasingly yanking their deposits.

The banks appear to be exhausting their capacities to wring cash out of the European Central Bank, the lender of last resort for much of Southern Europe's battered financial system [see this discussion on how the National Central Banks fund this lending].

The problems have been building since last fall. But the recent intensification has sent Spanish officials scrambling to prevent their banking system's liquidity problems from escalating into an acute financial crisis. Many experts expect the ECB to ride to the rescue on Thursday by making it easier for euro-zone banks to borrow money from it. [the only way it can make it easier is by loosening the collateral requirements]

In one sign of the mounting pressures, the Bank of Spain appears to have started providing emergency loans to some of the country's banks, according to central-bank data and industry officials [this is alarming because it means that some Spanish banks have run out of eligible collateral].
...

Now the collateral problem is rearing up again, with analysts saying some Spanish banks are running low on eligible assets. [see this discussion on how Spain has been desperately trying to come up with new forms of structured securities collateral]

UBS's Alastair Ryan reckons that the Spanish industry is holding a total of about €169 billion of government bonds that could serve as collateral for ECB loans, but that masks the fact that, individually, some lenders have a shortage of collateral. Other assets, such as mortgages, already have been deployed in covered bonds and other securities, so aren't available for future borrowings, Mr. Ryan said.

Emergency lending has been used by Ireland (discussed here) and by Greece (discussed here). This is the first indication that Spain's central bank is now deploying this program as well. It explains the urgency behind Rajoy's visit to Germany to expedite Spain's bailout. He wants to make sure if he asks for support, Germany isn't going to block it.

Reuters: - "The worst thing that could happen is Spain asks for aid and Germany blocks it," said a senior European diplomat.

Last week Rajoy met French President Francois Hollande who nudged him to ask for help before October to give European leaders time to consider it before an Oct. 19-19 summit.

But Rajoy told Hollande he was getting mixed messages from Germany, according to a source who was briefed on the meeting.

Berlin wants more details of the problems in Spanish banks, including the results of an audit by global accounting firms due later this month, and regions, which will get 45 billion euros from Spain's central government this year, before backing a bailout.

Spain has already been promised up to 100 billion euros of European money to keep its banks afloat. A sovereign bailout could deplete the region's rescue funds, the EFSF and the new ESM that will be the euro zone's permanent rescue fund.

And all this needs to happen fast - before Spain's government budget trajectory (see this discussion) becomes unacceptable to the ECB and the backers of the bond-buying program (particularly in Germany). Signs of budget plans being derailed are already there.

The Guardian: - Increased unemployment benefit payments are already putting pressure on Rajoy's budget plans, with figures released on Tuesday showing a 5% increase for the first seven months of the year. The budget minister, Cristóbal Montoro, had predicted that benefit payments, which fall over time for the long-term unemployed, would actually come down by 5% this year.

It's difficult to overstate the urgency of Spain's predicament. If the ECB falls short of discussing the full plan for securities purchases this Thursday (with sufficient amount of detail), periphery bonds and other risk assets will see a sharp selloff. Expectations are high and market participants could be in for a disappointment.

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Portugal's biggest risk is Spain

Portugal has been trying to export its way out of the economic mess that it has been in for some time. And it has been doing an amazing job, particularly given its poor export track record and deteriorating economic conditions in the Eurozone. Portugal's exports now make up close to 40% of its GDP vs. 25%  3 years ago. The nation's trade deficit has nearly disappeared in part due to falling domestic demand but also to improved exports.

Source: CS

Unfortunately for Portugal, its main trading partner continues to be Spain. And that presents the greatest risk to Portugal's recovery. Should Spain's recession deepen (for example similar to that of Italy or even worse), Portugal could be in serious trouble.

Credit Suisse: - ... the performance of Portugal is all the more impressive considering its strong economic linkages with its neighbour, Spain. This is really the key risk for Portugal going forward. Indeed, the success of its adjustment relies on the speed at which it adjusts its growth model toward a more export-driven one. The weaker its trade partners, the slower the adjustment.

The markets are beginning to absorb Portugal's recent economic successes (including a number of positive structural changes) as well as the fact that its future prospects for recovery are strongly tied to that of Spain. The spread between sovereign risk premia of the two nations has declined materially. Going forward the CDS spreads of Portugal and Spain will also become increasingly more correlated as shocks to Spain's economic growth will quickly be reflected in Portugal's export-heavy GDP.

Portugal and Spain 5y CDS (Bloomberg)

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Six indicators pointing to China's deteriorating conditions

China's slowing economy continues to pose a major risk to global growth. Here are a number of updates to the developments discussed earlier (see this post).

1. Imported iron ore prices continue to decline. Stories abound of desperate sellers dumping at below official market levels and buyers defaulting on purchase agreements. Steel prices are at new recent lows as well and the steel industry is in deep trouble. Part of the problem has been overproduction by steel mills owned by local governments who are in desperate need of revenue.

FT: Steel traders are also finding themselves in a desperate position. “We have to try every possible means to sell [our steel] even if we lose money. We will lose more if we don’t sell,” says a trader with a large steel trading company in Henan province.

Another reason for the slump in China’s steel markets is the unique structure of China’s state-dominated steel sector. This year Chinese mills have maintained high levels of steel production – even when running at a loss – rather than shutting down their furnaces, because many state-owned mills are incentivised to maximise revenues instead of profit. Revenues from steel mills means more tax revenues for the local government, their ultimate owners.

China import Iron Ore Fines 62% Fe spot (CFR Tianjin port) USD/metric tonne (Bloomberg)

2. Exports are slowing. The ISI Group combined the official and the Markit PMI numbers into a single set of indices. Here is the chart for the exports portion of the PMI.

Source: ISI Group

3. ... While finished goods inventories are rising (also discussed here).

Source: ISI Group

4. Housing prices have actually been rising (also see this discussion). At first glance this may be an indication of good news, but it actually points to an escalating battle between Beijing and the local governments. Beijing wants to keep housing prices under control to prevent a housing bubble driven by speculation. China's municipalities don't want the music to stop because land and housing has made politicians and their friends rich and continues to provide government funding. The central government will push even harder to tighten controls on housing sales practices in an attempt to arrest these increases. This will make implementation of stimulus programs more difficult (see this discussion).

Source: ISI Group

5. China's banking sector is now under pressure as "bad loans" begin to rise. On one hand local businesses are complaining to their politicians that banks are refusing to roll some existing loans - while politicians pressure banks to do so. On the other hand bank regulators don't want to see non-performing loans increase. Much has been swept under the rug for now because the definition of "nonperforming" is still in the eyes of the lender.

China Daily: - China's commercial banks are facing a high risk of increased bad loans, partly due to a lending spree to support massive economic stimulus three years ago.

That risk might worsen as local governments have attempted to unleash a new round of stimulus packages amid the current economic downturn, market analysts have warned.

Seven out of the 16 Chinese listed banks reported a rise in their Non-Performing Loan ratios in the first half of 2012, according to their interim reports.

6. Finally, China's stock market hit another post-09 low this morning, continuing this relentless bear market in domestically listed shares.

Shanghai Stock Exchange Composite Index (Bloomberg)

Of course as data shows worsening economic conditions across the board, the propaganda machine from China's official media gets turned up.

People's Daily: - Rational economists are confident about the future of the Chinese economy. They believe that the internal factors driving China’s economic growth are expanding steadily. Rapid urbanization, huge consumption potential, and the rebalancing of China’s growth toward western regions will further unleash the country’s growth potential, and provide lasting impetus to its economic growth.

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The Australian dollar is still vulnerable to the downside

The Australian dollar has declined considerably from the recent highs (touching a 6-week low). But given the China slowdown and weakening domestic fundamentals in Australia, it may have room to fall further. Clearly relative to the rest of the developed markets nations, Australian economy is in decent shape, but is it good enough to justify the current AUD levels (1.0247)? Here are some reasons that show risks to the downside for the Australian currency.

1. Australia's sales for have been lackluster recently.

Source: GS

2. Construction seems to be slowing with building approvals down 11% YoY and new home sales down 5.6% for the month.

3. Exports have come under pressure with export growth coming in lower than expected last month.

4. Business and consumer credit growth has weakened somewhat as well.

5. There is also an expectation that the RBA (the central bank) will lower rates this year - which is not great for the currency.

6. The most telling sign of potential further declines for AUD however is the following chart that compares AUD with copper prices. Given Australia's commodity driven boom of recent years, this divergence is quite telling.

AUD vs. copper (Bloomberg)

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Long term real rates in the US hit record lows

The long term US real rates have touched a new low. The difference between the 10y zero coupon treasury yield and the 10y zero coupon inflation swap rate is now around -88bp. That's roughly how much you'd lose in real terms per year holding long term treasuries.

10y zero coupon treasury yield -10y zero coupon inflation swap (Bloomberg)

The American savers and retirees all want to thank Bernanke for making their cash savings dwindle even as they lock them up in long-term treasuries to get a "better" nominal rate (see this post on impact of low rates on the economy).

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The crowded long dollar trade is no longer crowded

Remember the crowded trade in long USD positions (discussed here)? Well, it's not crowded any more as many of the longs have been blown out. The sentiment has quickly shifted (of you wonder why, just read this) and the short dollar bias is currently in place. The speculative futures players net exposure (from CFTC) shows them now to be net short the dollar.

Source: GS Research

Reuters: - Currency speculators turned negative on the U.S. dollar in the latest week for the first time in nearly a year, according to data from the Commodity Futures Trading Commission released on Friday. The value of the U.S. dollar's short position totaled $441.7 million from a net long position of position of $4.57 billion the previous week. It's the first net short position on the dollar since the week of Sept. 6, 2011. To be short a currency is to bet it will fall in value, while being long is a view its value will rise.

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