The ‘Instant Bullish’ effect seen in the stock markets is suspicious. The markets were melting down days ago, now comes a turnaround with the crisis that has threatened world stability nowhere in evidence …

It’s like happy days really here again: everything is too good to be true.

Obviously, somebody has been bailed out, the question is who and by whom?

The related question is whether Fed Quantitative easing underway though the ‘back door’: foreign currency swap lines with the Fed purchasing French and Italian bond issues by way of the ECB?

The timing is suspicious: stock markets around the world were vomiting until three days ago when the ECB started the unsterilized purchase of French and Italian bonds.

 

French Bonds Rally on Vow To Maintain Deficit Pledge as GDP Growth Stalls

Lukanyo Mnyanda and Paul Dobson (Bloomberg)

French 10-year bonds rose, pushing the extra yield investors get to hold them instead of benchmark German bunds to the least in two weeks, as the nation’s finance minister vowed to meet deficit-reduction targets.

Spanish and Italian 10-year bond yields extended their biggest weekly drop in the euro era after the European Central Bank bought the securities this week, according to people familiar with the deals. German notes slipped as equities advanced and the ECB said overnight lending to financial institutions fell yesterday from a three-month high. France’s government will hold firm to its economic targets and its growth forecasts, Finance Minister Francois Baroin said.

“The idea that they’re looking to add austerity and get their financial house in order has been a good fillip to the market,” Orlando Green, a fixed-income strategist at Credit Agricole Corporate & Investment Bank in London, said of France.

 

ECB buys up Spanish and Italian bonds, yields fall

William James (Reuters)

Italian and Spanish yields fell on Tuesday as traders said the ECB was intervening in markets to buy up the countries’ bonds, pushing borrowing costs towards more sustainable levels in a bid to stop the euro zone’s
spreading debt crisis.

Bund futures FGBLc1 traded in a wide range, led by extreme volatility in equity markets where concerns the global economy could tip into recession hit appetite for riskier assets.

The European Central Bank was again seen buying bonds after it became a reluctant owner of Italian and Spanish debt for the first time on Monday in an emergency response to head off mounting pressure on the highly-indebted sovereigns.

“We have seen enquiries and we have dealt with them (central banks),” one trader said. Another said that buying was focused more heavily on Italian paper than Spanish. Market estimates of the scale of ECB buying over the last two days varied with conservative estimates as low as 3.5 billion euros, while some said as much as 9 billion had been purchased. Traders said buying had been focused in the five- to 10-year maturities.

That support has seen yields fall by over one full percentage point on 10-year Italian and Spanish debt. The Italian yield was down 18.3 basis points on the day at 5.146 percent while Spanish debt stood at 5.036 percent, down 17.3 bps.

 

It takes more to move the credit markets against the surging tide of default risk than a measly five- or ten billion euro bond purchase. Purchases in hundred-billion euro increments are necessary. The total euro debt at risk by Spain and Italy — in addition to the impaired sovereign debt of the current wards Eire, Portugal and Greece — is over two trillion euros. Where does the peewee ECB get that kind of money? Trichet isn’t going to go out on a limb and simply print the money without something or someone covering his butt. That ‘someone’ isn’t Angela Merkel or Nicolas Sarkozy: for one reason, they don’t have the money!

The Bundesbank isn’t going to print up trillions of fiat euros. It and the French central bank could and probably should in the short term but they won’t. The Eurobankers possess neither the scope nor the ambition, that inflationary “Sun in the belly”.

The ECB is not a national central bank like the Fed or the Bank of England or Peoples Bank of China. ECB operations are constrained by treaty but more so by structure. There is no European treasury or centralized fiscal political entity to act as the ECB counterparty: there is nothing/no one to issue ‘national’ debt that the ECB can buy with its printed offal. The ECB is a bulbous version of a lowly neighborhood bank. It requires its own ‘lender of last resort’. Without larger balance sheets elsewhere to act as landfills for its toxic debt, the ECB can become insolvent and fail.

The ECB was intended to be a clearinghouse, to manage members current accounts and clear forex transactions. It lacks the institutional means to be a lender of last resort. Individual euro members were to keep their own finances in order as a condition of membership. Individual members would make independent credit arrangements with other EU members in the event of emergencies. These were never imagined to include all the EU members at once or impairment of all EU debt. Mechanisms were not put in place for the Eurozone to respond to crises as an actual fiscal or political union: this has been a criticism of the EU since its formation.

The common means to address the crisis so far has been the EFSF which borrows in the name of the euro collective. It has no funds or money-creation ability of its own, but must gather funds from members. At this point the debt situation is absurd: the GDP of the Eurozone is $16 trillion, the largest in the world. This economic powerhouse cannot gather the resources to backstop … relative to itself … a small amount of impaired loans! It is as if the solvency of the US as a whole was leveraged to a handful of individual states.

In a period when the demand for finance safety is acute the EU cannot bring forward European equivalents to the Treasury bills, notes and bonds or a marketplace for these issues. This is a failure of capitalism along with imagination. Trans-European debt issues would certainly be as valuable as the American equivalents. A European Treasury would have assets to sell. These would be tools to address debt impairment and allow orderly restructuring. With no Treasury and no assets the policy makers are left with empty hands!

The purchase of piddling amounts of Greek, Irish and Portuguese debt has left the ECB orbiting the floor drain. It cannot sterilize massive amounts of new euro debt in disordered credit markets: the amount of impaired debt is too great. Meanwhile, there is nothing currently on the ECB’s account that would attract a willing buyer at anything close to par. The debt of the individual members outside of Germany’s and a few others isn’t worth very much. Not even the Chinese want it.

 

 

The euro was was always an energy hedge, never intended as a rational means of financing any sort of ‘Grande European Enterprise’.

With euros in hand ‘members’ would break the US’s seigniorage monopoly. Instead of having to ‘buy’ dollars with labor the Europeans could simply print euros as needed. European fuel importers would escape the dollar-centric foreign exchange markets. A guzzling European whether Spanish or Netherlander — or Greek or Irish — would offer a euro to the oil producers in the Middle East that would be as valuable as a dollar or more so. Europeans would avoid the humiliation of buying over-pricey bucks before buying fuel or having to offer depreciating pesetas, punts or drachmas. Wealth saved in this manner would be directed toward European manufacturers financiers, increasing (finance) ‘growth’ and ‘prosperity’.

To the sheiks, every European would be seen as equal to the thrifty German. The euro would combine the purchasing power of an entire continent. At the same time, it would allow the peripheral Europeans to enjoy a wasteful lifestyle identical to that of Americans. The scheme was very suggestive and self-referencing.

Unfortunately, trend crude prices above the (dis)comfort zone of $50-60 a barrel have smashed the euro hedge, just as the same prices have pounded the other fuel price hedges into rubble: two of these being the ‘outsourcing labor to China’ hedge and the ‘inflating asset price bubbles’ hedge. Brent crude today is a crushing $107 per barrel. A victim or its own financial and mercantile success, the Eurozone cannot afford fuel and service debts. Both together cost too much; without the one the other is kaput.

Enter Bernanke: there is nothing to stop the Fed Boss from a) being the hero and b) buying French and Italian bonds using the ECB as a straw purchaser … the same way pimply teenagers wheedle adults into buying beer and cigarettes for them at a a 7-Eleven. The process is simple: Bernanke would make an informal commitment to Trichet to purchase a trillion euros worth of … ahem … ‘High Quality’ Spanish and Italian as well as … (cough) higher quality French bonds by way of the Fed’s foreign exchange desk. Nobody would know and the Fed if asked would admit to a ‘slight’ increase in euro-denominated ‘reserves’. How slight an increase would be a question mark until the next Fed audit … ten years from now.

The Fed can park the bonds out of the sight of prying eyes on primary dealer balance sheets, keeping them off its own at the same time. Bernanke buying European bonds would be doubling down, gambling now as he has been since 2008 that the furor in the EU will die down soon and that he can unwind his ‘bond trades’ into some sort of … market. In the meantime, stock markets would rise, as they did beginning last summer with QE 2.

The Fed treats all credit problems as matters of liquidity. The Fed continually gambles with US citizens’ money for the benefit of Bernanke’s banker ‘friends’. As has been pointed out before, a friend will help you move, a real friend will help you move a body.

Many of the so-called European banks under default risk are primary dealers or have a long-standing business relationship with the Fed. These banks are quasi-national free-standing entities unto themselves: a Fed bailout in euros is the same as a Fed bailout to the same bank in dollars, roubles, yen, yuan, etc. Hello, QE3 …

A Bernanke commitment to buy a trillion or so EU bonds would be twice the size of QE2 and would have the more or less identical ‘Instant Bullish’ effect. QE would explain what we are seeing. Bernanke might have to buy another trillion or two on top of that. This is the level of buying required to move the market. It isn’t simply PIIGS debt under the default cloud but all of Europe’s.

If Bernanke is bailing out the EU, the effect will emerge soon enough in the form of a lower euro relative to the dollar. Perhaps the Fed realizes the EU energy balance sheet is already beyond hope.

Meanwhile, debts disappearing by way of deleveraging has wealth disappearing at the same time. Wealth and debt are two sides of the same coin. Wealth seeks to maintain itself by shifting the debt ‘costs’ onto others. This shifting process has created a large problem for the Swiss.

Surrounded by crumbling euro economies and having a reputation for finance prudence, tiny Switzerland has been inundated with flight capital. The desperate wealthy flock to the perception of safety swapping euros for rock solid francs, undermining the Swiss economy in the process. Supply and demand: there are few francs ‘for sale
relative to the massive float of euros being offered by the wealth refugees. The value of the franc has been rising sharply as a result. In turn, the rising franc has become a painful headache for Swiss businesses that rely on exports as wells as for lenders holding loans denominated in francs and for Swiss dependent on foreign visitor spending.

A rising franc amplifies exporter failure. Swiss products through no fault of their own become un-competitively expensive. The rising currency means franc debts outside of Switzerland are increasingly onerous to service. Franc loans have increased dramatically in ‘real’ value relative to earning power denominated in local currencies. Property/collateral values for franc loans have fallen as well. Continually increasing franc value makes default more certain: the consequence will be insolvent Swiss lenders. The flood of euros seeking to escape euro bankruptcy is inadvertently pricing Swiss enterprises into ‘francruptcy’.

The Swiss central bank has taken heroic rear-guard actions such as buying euros (and losing billion$ in the process), reducing short-term interest rates to zero and adding fiat francs into circulation. These efforts are hung with question marks (Broce Krasting):

 

Swiss to Join the EU – NOT!

Both USDCHF and EURCHF are up on the day by a very big 5%. This is mega volatility. The “book” and cash gains and losses are staggering. Some finance ministers are sighing relief over this. I look it at and just see extreme instability.

No doubt but that the Swissie was overbought against all crosses. Some type of correction was in order. The Swiss National Bank has dumped a ton of liquidity (CHF 90B) on the market. This has pushed Swiss rates below zero. This distortion contributed to today’s reversal. But it was a story out of Zurich that Switzerland was contemplating joining the EU that was the real catalyst for the reversal. Some details.

An SNB VP, Thomas Jordan, had this to say: (my translation and original text)

 

Die Schweizerische Nationalbank (SNB) kann sich vorstellen den Franken vorübergehend an den Euro zu binden

The SNB may consider a temporary link to the Euro.

 

This was the sentence that got the markets roaring. The TV folks jumped on this “good news” story. But they left out the next sentence:

A permanent connection of the franc to the euro, however, is not compatible with the laws of the Swiss constitution.

 

Eine permanente Anbindung des Frankens an den Euro hält die SNB indes für mit ihrem Verfassungsauftrag nicht vereinbar.

 

For Switzerland to join the EU and abandon the Franc as the national currency it would require a national referendum and a change of the constitution. It was 160 years ago in 1850 that Switzerland established the law that ensured they would be a global reserve currency. That decision has paid dividends to the Swiss damn near every year since. I see little prospect for such a major change anytime soon.

A similar approach was defeated in 2001. At that time the Euro zone was thriving with the reduced inflation and expanded debt market that Euro intergration first brought. The Swiss didn’t want any part of the EU when things were good. It’s very unlikely they would want to sign up when things are falling apart.”

 

The Swiss try to offset or sterilize the flood of euros. They’ve hinted a franc-euro peg and have insisted that they will keep the fiat flowing. Hedges are in place to narrow mortgage loan exposure to franc appreciation in Eastern Europe. The Swiss have their fingers crossed as the flight into the Swiss lifeboat shows no sign of abating. Here is Switzerland’s problem: the EU is not under a temporary ‘stress test’ but exposed to a new set of operating conditions, the most important being energy- and resource depletion.

The Swiss need to impose capital controls. Right now the Swiss are facing the ‘Unholy Trinity’ something that has been discussed here before:

 

With limits to monetary policy in place due to liquidity traps, worldwide ZIRP and the dollar/crude trade pricing currency, the Swiss can either peg the franc to the euro or limit the flow of flight capital. The defacto euro peg has proven very costly to the Swiss to defend, best to establish controls and hedge its currency exposure at the same time.

There are a number of academic papers on the implementation of capital controls during the South Asian finance crisis in 1998. While conditions differ between Switzerland today and Malaysia in 1009, the basic problem of capital flight both in and out of an economy is identical. The important idea is to match risk to the source. This is directly done with capital controls as they can be applied to the flight capital specifically rather than spread across the ranks of currency users.

Direct controls would require flight capital to make an investment choice rather than simply use the country as a currency parking lot. Capital can make longer-term investments in the Swiss economy, while accepting flight-associated risks or it can choose another lifeboat. It isn’t unreasonable to demand flight capital carry the risks the flight dynamic itself creates.

The Swiss could identify publicly traded businesses most at risk from currency appreciation: exporters, banks and visitor sensitive interests. They could then mandate any incoming euro capital be invested as equity in these companies at the market rate. In this way, the effect of currency appreciation on businesses and their capital would be offset by increases in companies’ capital stock. A Swiss bank invested in franc loans could be guaranteed of capital adequacy in the face of credit losses due to flight capital-driven franc appreciation. Equity investment would be required for a minimum of three years or longer if conditions warrant.

Other kinds of capital controls can also be imposed, such as transfer taxes and additional redemption constraints. If flight capital is unwilling to accept currency-related risks the capital should look toward more liquid markets where risks are more easily absorbed such as the dollar market.

Capital controls would cost the Swiss very little to implement. The bank regulators could simply make new rules regarding incoming capital. Certainly the Swiss banks would support it for the same reason: more equity would offset foreign exchange-related risk.

The euro establishment would howl if the Swiss implemented capital controls and might look to retaliation. Disappearing debt equals disappearing wealth: it isn’t the Swiss peoples’ responsibility to accept risks associated with debts they themselves have never taken on in order to preserve others’ wealth.

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