Europe Will Climb That Same Wall of Worry

By Kevin Muir of The Macro Tourist

Although sentiment towards European equities has improved since I wrote about it last Fall (Pretty sure I am alone in this trade), this opportunity is not something that will be quickly arbitraged away. Not only that, but deep down, investors are still skeptical about the long term prospects for European equities. Sure, they are willing to surf European equities for a wave or two, but ask them where they are willing to invest for the long haul, and Europe is rarely in the running as a top pick.

I understand their pessimism. Europe has a lot of problems. Poor demographics, an unstable political union, layers of bureaucracy, the list goes on and on. It’s tough to imagine Europe being a great place to park your money.

Yet too many investors mistakenly believe good old fashioned fundamentals still drive financial asset markets. Nothing could be further from the truth. Since the 2008 credit crisis, Central Bank flows have made a mockery of financial pricing theory.

How do you determine the fair value of assets, when the risk free rate which most other assets are priced off, is negative?

Try putting negative yields (or even just tiny yields) into the Fed equation model and figure out the price for a stock index.

The current situation in Europe is remarkably similar to the U.S. period of 2010 to 2014. At that time, most investors were extremely negative about America’s prospects. Many investors called it a “sugar high” induced by the Fed’s continual balance sheet expansion. There were all sorts of forecasts of doom. Yet stocks kept climbing… and climbing.

The same thing will most likely happen in Europe. The ECB is aggressively expanding their balance sheet, and they have even pushed short term rates to absurdly negative levels. Their monetary policy is just bat shit crazy.

Continue reading Europe Will Climb That Same Wall of Worry

If an Electorate Falls in the Forest, is Their Voice Heard?

By Danielle DiMartino Booth

If an electorate falls in the forest, is their voice heard?, Danielle DiMartino Booth, @dimartinobooth, Fed Up

Quizzically-inclined quantum physicists quench their intellectuality by quoting philosophers first, then their fellow scientists

It is in fact questionable whether quantum physics would have come into being if not for George Berkeley’s 1710, “A Treatise Concerning the Principles of Human Knowledge.” Berkeley’s most famous saying is, ‘esse est percipi,’ or, ‘to be is to be perceived.’ He elaborated using the following examples:

“The objects of sense exist only when they are perceived: the trees therefore are in the garden, or the chairs in the parlour, no longer than while there is some body by to perceive them.” So matters of matter exist only in our mind. It is critical to note that Berkeley never posed a question but rather he made a statement of the world view through his metaphysical personal prism.

It was not until the June 1883 publication of the magazine The Chautauquan that the question was put as such: “If a tree were to fall on an island where there were no human beings would there be any sound?” Rather than pause to ponder, the answer followed that, “No. Sound is the sensation excited in the ear when the air or other medium is set in motion.”

A vexatious debate has ensued ever since, one that eventually stumped the great Albert Einstein who finally declared “God does not play dice.” In recognizing this, Einstein also resolved himself to the quantum physics conclusion, that there is no way to precisely predict where individual electrons can be found – unless, that is, you’re Divine.

Odds are high that the establishment, which looks to ride away with upcoming European elections, is emboldened by quantum physics. The entrenched parties appear set to retain their power holds, in some cases by the thinnest of margins. What is it the French say about la plus ca change? Is it truly the case that the more things change the more they stay the same?

Is this state of stasis sustainable, you might be asking? Clearly the cushy assumption is that the voices of those whose votes will not result in change will be as good as uncast, unheard and unremarkable.

Except…and this is a big ‘except’ – time is on the side of the castigated and for one simple reason – they are young. Consider Great Britain’s majority decision to leave the European Union (EU). An un-astonishing 59 percent of pensioners voted to leave the EU while only 19 percent of those between the ages of 18 and 24 supported Brexit. The aged see the EU as a cash drain at just the wrong time, and for good reason while the young view those 28 member states as the land(s) of opportunities.

With the caveat that polling has been revealed to be anything but reliable, young voters in France see things a might bit differently. Nearly half of surveyed French youth say they will vote for far-right candidate Marie Le Pen. At the opposite end of the spectrum, the dark horse far-left candidate, Jean-Luc Melechon, has enjoyed a late-stage surge in the polls by vowing to increase wages and shorten workweeks. Both insurgent camps view the lead contender, former banker Emmanuel Macron as the epitome of elitism, their ‘Hillary.’

Polls show the initial round of voting, which takes place on April 23rd, will make Macron sweat, but that he will survive to stand as the strongest contender in the second round. The status quo thus prevails, which for many represents continued economic stagnation and evasion of fiscal reforms.

Now factor in the rising recognition of the fallibility and limitations of central bankers. Mario Draghi, encouraged shall we say by the Germans, looks set to begin tapping the brakes on Europe’s answer to quantitative easing. Let’s be clear. Draghi has made it plain that he won’t go down without a fight. Nonetheless, it appears monetary policy will slowly become less accommodating, dragging on growth in the peripheral countries.

And then there is the matter of the refugee crisis, the cost of which few in the United States fully appreciate. Faced with impossible living conditions and no access to work in Jordan, Turkey and Lebanon, hundreds of thousands have opted to risk the journey to Europe. In 2015, 1.3 million asylum seekers landed in Europe, half of whom traced their origins to Syria, Afghanistan and Iraq. That number plunged in 2016 to 364,000 owing mainly to a deal between the EU and Turkey which blocks the flow of migrants to Europe.

The cost, not surprisingly, is enormous. Europeans spend at least $30,000 for every refugee who lands on her shores. By some estimates, the cost would have been one-tenth that, as in $3,000 per refugee, had the journey to Europe NOT been made in the first place.

Of course, aid money helps cover the cost of the crisis. Some $15.4 billion, about 10 percent of global aid monies raised in 2016, was directed to hosting and processing migrants in developed countries last year. While charity lessens the burden, it can’t staunch anger at headline-grabbing statistics claiming that Chancellor Angela Merkel’s ‘failed migrant policy’ will cost German and EU taxpayers $46 billion in the two years ending 2017.

Fear thee not, the consensus is that September’s elections in Germany will come and go with little to no fanfare; pro-Europe candidates enjoy wide leads in the polls. Many macroeconomists expect the year to end with the strongest ties in generations between Germany and the rest of the eurozone, led by France. Bullish analysts expect the euro to shake its jitters and end the year above €1.10.

The biggest obstacle to a happy ending, for the time being at least, comes down to Italy. General elections must take place by May 2018 but an early vote remains a possibility if the current prime minister of the eurozone’s third-largest economy does not survive the year. Investors, for their part, yawn at the mention of Italy. As the Wall Street Journal pointed out in a recent story, numbness tends to set in after 44 governments have come and gone in the space of 50 years.

The most recent survey revealed a record one-in-three Italians would vote the Five-Star Movement into power if elections took place today. The rebellious, populist party has tapped the anxieties of Italians whose per capita economic output has suffered the most since the euro was formed in 1999. Even the Greeks can claim to have suffered less.

Is an Italian uprising in the cards? The bond market certainly doesn’t buy into the potential for major disruption, grazie Signore Draghi.

At some point demographics will start to matter. The situation in France is no doubt grave, with youth unemployment at nearly 24 percent. But that pales in comparison to Italy where 39 percent of its young workers don’t have jobs to go to, day in and day out. Older voters determined to keep the establishment intact will begin to die off. In their wake will be a growing majority of voters who are increasingly disenfranchised, disaffected and despondent.

If there’s one lesson Europeans can glean from their allies across the Atlantic, it’s that bullets can be dodged, but not indefinitely. As we are learning the hard way, necessary reforms are challenging to enact. Avoidance, though, will only succeed in feeding anger and despair. The longer the voices of the desperate go unheard, as just so many silently falling trees in the forest, the more piercing their cries will be in the end.

One Small (But Important) View of ‘Dollars’ From Europe

By Jeffrey Snider of Alhambra

In short, European banks are right now more disturbed by “dollar” problems than of anything else

Nothing says “fixed” quite like bureaucrats responding to a past crisis they did not foresee (and in the case of European bureaucrats, actively denied while it was happening) by establishing more layers of bureaucracies to “prevent” it from happening again. It is the most predictable result in all of finance and money as the government acting so busily to assure the public by creating rules and shifting power, always to their own advantage. Never mind that no crisis ever repeats, there will always be rules aplenty for the “last” one though never for the next one.

In 2009, European Union officials tasked a High Level Group (that’s the official classification; nothing displays the self-importance and credentialed “acumen” quite like High Level Group) chaired by Jacques de Larosière to come up with ways of protecting Europe’s “citizens” from really matters to that point unknown. De Larosière was a French bureaucrat who was probably the prefect representation of the effort. He had been appointed Managing Director of the IMF in 1978 after spending a decade and a half in French Treasury Department. There, de Larosière had even been a member of the French delegation to the Smithsonian Agreement, meaning that he had no shortage of experience in crafting government solutions that would ultimately accomplish little to nothing of value.

The work of the High Level Group centered around all the usual stuff, the limited hindsight provided by orthodox economists who themselves had very little idea what had happened. As is usual in these cases, they end up throwing a bunch of impressive (sounding) numbers together and stress how these numbers will be useful in the foreseeable future. The result in late 2009 was an unimpressive report that became the framework by late 2010 for the European Systemic Risk Board (ESRB). Almost immediately, the European system plunged into renewed crisis that, of course, the ESRB had no idea was coming.

Though the ineffectiveness of the ESRB has actually been established, it continues to publish its numbers anyway. Among them is its quarterly Risk Dashboard, an attempt at a comprehensive review of European banking and money. The first was published at the end of August 2012, and given the situation throughout the two years of turmoil before it, that first Risk Dashboard was given a prominent disclaimer that has not left its pages:

The dashboard is a set of quantitative indicators and not an early warning system. Users may not rely on the indicators as a basis for any mechanical form of inference.

They could not have possibly written otherwise because, as they would later claim, they issued and declared no warning in the middle of 2011 despite all these numbers even though that was their whole job. Instead, the ESRB was busy at that time establishing all the rules and bureaucratic operating procedures that it would use all the while European banks were plagued, again, by a huge degree of risk of systemic shock. It is the means and method of that shock that was and is of great interest.

Section 4 of the Risk Dashboard consists of several “liquidity indications”, which are meant to measure funding strains. Among them is one for the European “money market”, showing very clearly the problems in 2008 as well as 2011.

By this view, however, money market conditions since late 2014 are the best they have ever been. The reason, obviously, is ECB monetary policy as it relates to what are still classified as money markets, even though they function in ways that are entirely unlike them.

Collating the ESRB number with the relevant parts of the ECB’s simple balance sheet shows that the last few years for European banks have indeed been unlike the prior systemic problems mentioned before.

It’s one primary reason why as Deutsche Bank’s stock fell mainstream commentary fixated on the US DOJ settlement as the primary culprit – even though it was European bank stocks in general that were under pressure. If money markets in euros are no longer much like functioning money markets, then it would make sense that stress would appear in other places. The ESRB also produces a separate liquidity measure, though for some reason it is a combination of stock prices, bond metrics, and foreign exchange numbers.

Though no warning is evident here, it is much less ribald than the money market figure. That leaves only cross currency basis swaps as anything signaling any degree of concern.

Immediately, you can see the difference with those created quantitative figures, as well as across several additional dimensions. Basis swap premiums for obtained dollars have been falling steadily since the early days of 2014 when, among other things, CNY “unexpectedly” started lower and the ECB decided to “stimulate” with negative money market interest rates and more balance sheet expansion. Unlike 2011 or 2008, basis swaps are not lower all at once; it has been instead a slow burn, an almost steady withdrawal stretched out over just about three years and with no end yet in sight.

The direction of the negative basis swap premiums is the only suggestion necessary; the more negative the premium, the more desperate from the European perspective the European demand for dollars (really “dollars”). It was the spring/summer of 2015 where this imbalance, a systemic one no less, became especially difficult and disruptive. Given the results in the European economy throughout this time period as entirely different from the promises for it, it is safe to write that the ESRB was watching its money market indicator more closely than the cross currency basis swaps that presented European banks, and thus the European system, and thus Europeans, with funding risks primarily of “dollars” than euros.

That is the key difference we see from 2011; there is no shortage of euros this time around. The ECB engaged in balance sheet expansion so that European money markets are now highly negative in “yield.” What might be wrong in Europe, then, is outside of euros even though like the ECB the Federal Reserve had itself engaged in large programs of quantitative easing ostensibly in dollars. Therefore, the key distinction that we can observe just in the liquidity portion of the ESRB’s Risk Dashboard for Europe is not between dollars and euros, but rather indirectly between dollars and “dollars.”

In short, European banks are right now more disturbed by “dollar” problems than of anything else. Since that is the only monetary indication of concern and Europe’s economy has acted more consistent with that concern than of anything like QE, then Europe’s economy as well as markets is exhibiting “dollar” problems almost exclusively. It is a good example of the eurodollar system that while in retreat or decay still continues to evolve (though never restore).

That means that what is truly inconsistent across all currencies in the wholesale setting is that bank reserves are nothing more than a useless, perhaps confusing set of numbers without bearing on actual financial conditions. That was true in 2011 and 2012, but even more so now as the temperament of the global “dollar” system has become even more centered around forex than what was still somewhat recognizable as traditional currency formats. The global economy, again, looks nothing like the positivity of the money market indicator but everything like the trajectory of cross currency basis swaps that aren’t even tabulated by the ESRB but are added from Bloomberg.

As poorly as the ESRB has performed (though they would and have pointed out that there have been no systemic failures under their full administration after August 2012, an especially low standard that while correct doesn’t quite meet its own Mission Statement), they have at least included the one set of relevant numbers in their ongoing assessments that you won’t find anywhere near Federal Reserve policy or public discussion of Federal Reserve policy. The ESRB has appeared to have at least grasped that there just might be “something” else going on.

Having focused so much on how the current condition seems a close repeat of 2013, there are also differences that must be factored; though, in the end, they are likely to establish how what followed 2013 is likely to repeat all over again, too.

ECB QE Doing Opposite of Objective

By Tom McCellan

ECB QE Doing Opposite of Objective

ECB Assets versus DAX Index
June 09, 2016

I like to say that there are only 2 fundamental factors which matter for the overall stock market:

1. How much money is there?

2. How much does that money want to be invested?

Change either of those, and the market will move up or down.  But 2016 is showing us a perverse version of that.  We are in opposite-world now.

The Fed has backed away from the QE game, and is wishing it could find a sufficient excuse to start normalizing interest rates.  But the rest of the world is heading into the world of negative interest rates, such that banks are contemplating expanding their vaults to hold cash in lieu of holding negative-yielding government and corporate bonds.  The idea is that pumping all of that extra money into the banking system should help lift the financial markets, and thus the actual economies of the countries involved.

This presumption of how market physics work persists in spite of the evidence indicating that it actually does the opposite of the intented effect.  This week’s chart shows that the correlation between Germany’s DAX Index and the size of the ECB’s balance sheet is at best non-existent, and perhaps more accurately it is a roughly inverse correlation.

When the ECB started expanding its balance sheet in earnest back in early 2015, Germany’s stock market responded by moving downward.  This makes no sense according to the popular theory that more money means higher stock prices.  But after a while it is time to revise the hypothesis in light of sufficient data.

There is a correlation is between ECB assets and gold, but with a twist.  The size of the ECB balance sheet correlates better with gold as priced in euros.

ECB assets versus gold priced in euros

It is not a perfect correlation, but it is a pretty good one for the overall trend.  The implication is that if Mario Draghi insists on continuing the ECB’s QE program, and running his continent’s banking system into the ground, then gold is likely to be the main beneficiary.  The European economy and stock markets, not so much.

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