It is a global economy. Europe is a mess. China is struggling. Whatever strength the U.S. economy had earlier this year has now dissipated. The theory that somehow the U.S. can “decouple” is taking a serious beating, and the even less realistic view that Germany could “decouple” is also being torn to shreds.
The current crisis has its roots in Europe and Europe needs to address it. European finances and debt are far too interconnected to make a Greece exit anything but a nightmare for Europe. Governments and the ECB have lent too much money to Greece, and to Ireland, and to Portugal, and to Spain, and to Italy. All the “backstops” and “firewalls” have the same governments and central banks lending more money. The plan is flawed and creates contagion. Greece may eventually leave, but not until Greece and the EU have done a lot more preparation and planning. In the meantime currency devaluation risk, even more than solvency risk, is putting the entire Spanish economy in jeopardy, with Italy not too far behind. This has to be addressed immediately.
The ECB has its interest rate policy announcement on June 6th. If they get through that announcement without a plan I think the markets could turn chaotic as “bank runs” accelerate in all the periphery countries. To buy some time, the ECB and EU don’t even need to do that much. A combination of actual bank recapitalizations, EFSF intervention in the secondary market or even the primary market, ESM being finalized (ideally with a banking license), project bonds, some new funding programs for banks, and a rate cut for good measure would do a lot. Germany will ultimately be the key. These programs will be far more successful in calming investor fears if Germany changes its attitude. If the Germans insist on “sticking to existing” programs and a refusal to “monetize” then the plans will have limited success. The tone Germany takes will have as much of a calming influence as the programs themselves.
Every Grexit scenario I think about ends in a rapid and chaotic dissolution of Europe and global trade. It won’t just be bad for all of Europe, it will be bad for the U.S. and for China. The scenarios where Greece leaves and there isn’t a run on banks in Spain and Italy just seem implausible. Sovereign bond prices in Europe reflect this where even some weak countries are trading well because of the belief they will retain a “strong” currency of some form. Europe may underestimate this risk, but given their propensity to “kick the can” I would be shocked if they don’t come up with some new ECB driven plan in the next few days. Merkel and Weidmann have both been very quiet of late, I believe that is because they are in the process of backing down and giving the EU some flexibility.
I’m not sure what the IMF is doing. I don’t expect them to do anything, but if you have a firewall (and they supposedly do), it might be a good time to use it and show some initiative. It is far easier to prevent panic than it is to try and stop panic once it has started. That is a lesson that seems obvious, yet has been ignored time and again during this crisis as the complexity of so many political agendas forces them to react too little, too late, too often.
What form will QE3 take? I think after this job report there should be little doubt that we will see more QE. Ben has been pretty open about what it will take to spur another round of QE and I think the criterion has been largely met. The jobs data has been weak. Housing has been mixed at best. There is little sign of inflation as the CRB index is plummeting and even ISM prices paid took a nosedive. MS CDS is right around 450 bps. It spiked to 500 last year, but I think it is near a level where the Fed grows concerned that they will have to deal with daily headlines about banks not wanting to face each other, etc. Too many elements all point to QE. I expect “it” to be announced on June 20th, but there is some possibility it could be done in conjunction with Europe on June 6th. In an ideal “risk-on” world China would announce some initiatives as well.
To have any meaningful impact on the economy (and not just the markets) QE3 will have to create money. The operation twist did little or nothing for stocks. Some people point out the performance of stocks since operation twist started, but I think the real driver behind global stocks market strength was LTRO and operation twist was fairly ineffective. So QE3 has to create money to have much of an impact. It also has to target mortgages or other “risky” credit instruments. The economy is not going to improve just because the 10 year bond yield is lower. That is NOT translating into benefits for the economy at large. Corporations are seeing some of the benefit as they have used the low rates to reduce interests cost and clean up their balance sheet, but it hasn’t done much for the average person or small business. New and robust credit creation has to happen and it has to be directed at the housing market. We cannot decouple from the global economy, but the housing market is the one area that is big enough to move the needle where we are largely in control of our own destiny. A QE that doesn’t target mortgages and try and boost housing will have minimal impact. Ideally, the program should target mortgages originated in 2012 and beyond. That way it could actually force new mortgages to be executed and provide real credit creation. It might take more time than some blanket desire to purchase mortgages, but would do a better job ensuring that the Fed’s intentions are transmitted into the economy. If it is just a broad mortgage program, I would be concerned that banks and funds that loaded up on mortgages in advance would benefit by selling them to the Fed but not really originate new mortgages. For me the keys to determining whether QE will be a big success or not are creating new money rather than some form of twist, and a focus on mortgages, particularly in a way that encourages new ones to be originated.
The markets heading into the weekend remain weak. I think we will see a strong rally into the close as people consider the possibility that central bank and policy intervention are likely and that the jobs data, while extremely weak, wasn’t yet negative.
There were some outliers today worth noticing. Spanish and Italian bonds actually performed well today. The 5 year bonds were 7 and 12 bps better on the day. That is a bit of a surprise given the carnage in other markets. HYG is down almost 1% again today. HY18, the CDS index is down just over ½ a point, so the ETF seems to be underperforming again. I am seeing HYG trade at a pretty significant discount and that is with shares outstanding actually increasing yesterday. HY cash is definitely quoted down, but limited trading. Looks like the bids got dropped fast enough not to get hit, and no one is so scared that they are indiscriminately hitting bids. That could change, but I would look to buy HYG here. For some “fast money” accounts the discount and relative liquidity of HYG and JNK could prove more tempting than trying to play the market via bonds or CDS.
IG18 is trading at 126 which isn’t quite 3 bps wider on the day. It first got above 120 back on May 17th when it closed at 123 and the S&P closed at 1304. It has tracked reasonably well, as it went tighter with stocks rallying and is right back out with stocks being weak. Although IG18 seems about in line with where it should be relative to stocks, I can’t help but think it is better behaved than I would have expected. It is trading poorly but doesn’t seem to have any element of panic and looks like dealers have pretty much stuck to ¾ bp markets all day long and didn’t have to widen that bid/offer spread to offset a lack of liquidity.
Have a great weekend.