Jumat, 15 Juni 2012

Despite an increased risk of more defaults, there is light at the end of the Eurozone tunnel

Rising yields on Spanish and Italian bonds point to an increased likelihood of painful defaults, but declining swap spreads point to an eventual Eurozone recovery. Central banks are not stimulating, they are reacting, as they should, to intense demand for liquidity; that allows financial markets to continue functioning, and that in turn is a necessary condition for an eventual economic recovery.

These charts confirm the headlines: the Eurozone is still plagued with serious problems. 2-yr sovereign yields, a good barometer of near-term default risk, are quite elevated for the weaker PIIGS (Portugal, Ireland, Spain, and Italy). Ireland and Portugal have gone to the back burner since late last year, while Spain and Italy are now front and center; they are the biggest PIIGS debtors, with $3 trillion between the two of them.

Greece is a basket case, having already defaulted; the only question there is whether the Greeks this weekend will vote to leave the European Union and the Euro or not. Greece's decision by itself won't matter much to the world economy or to the financial markets, but if Greece decides to exit the euro—a decision that sounds easy on the surface, but spells great pain and suffering for most of the Greek population—then markets will worry that that will be the beginning of the end for the euro. I think a Greek exit from the euro, should it happen, might prove to be a wake-up call for the rest of Europe, since the consequences are impoverishment of the private sector via a wealth transfer to the public sector. The only one who stands to gain from a devaluation is the public sector. Everyone else will see their net worth decline significantly, their living standards eroded, and the return of inflation.

With a Greek vote—and its potentially dire consequences—imminent, with markets fearful that Eurozone defaults may reach many hundreds of billions of euros, with bank runs making headlines, and with recessions afflicting most of the PIIGS economies, it is very surprising—and encouraging—to see that Eurozone 2-yr swap spreads have fallen to their lowest level since last August. At 27 bps, U.S. 2-yr swap spreads are about as close to "normal" as one could hope. This can only be evidence that central banks are fulfilling their "lender of last resort" function. Europeans are desperately seeking safe havens (e.g., 2-yr Treasury yields of 0.3%, 10-yr Treasury yields of 1.6%, gold at $1625/oz., 5-yr TIPS real yields of -1.2%), and European bank stocks have lost fully 83% of their market cap since 2007, thanks to their huge exposure to PIIGS debt. If the ECB and the Fed weren't willing to inject massive amounts of liquidity to compensate for the almost insatiable demand for liquidity, the Eurozone by now would have been in the throes of a depression and deflation and most banks would have been wiped out.

So when I see the Bloomberg headline "Stocks Rise on Central Bank Stimulus Bets," I think the spin is completely wrong. By injecting liquidity through quantitative easing and near-zero short-term interest rates, central banks are not stimulating anything, they are reacting—as they should—to extreme levels of fear that threaten to drain liquidity and freeze financial markets. To the extent that equity prices are rising even as Eurozone conditions are dire and the U.S. economy is growing at a measly 2% rate, it is not because central banks are going to fix everything by dumping more money into the system, it is because central bank actions are preventing what could otherwise be a financial crisis from becoming an economic crisis. In other words, the S&P 500 is up because the U.S. economy is not collapsing, not because the economy is getting ready to take off. As I've argued for a very long time, markets have been priced to extremely pessimistic assumptions, which means that as long as we avoid a catastrophe, then prices have room to rise.

The decline in Eurozone swap spreads this year is thus a down payment on the eventual end of the Eurozone crisis, just as the decline in U.S. swap spreads in late 2008/early 2009 preceded the end of the U.S. recession by some 6 months.

By forestalling a liquidity shortage and financial market meltdown, central banks are establishing the necessary conditions for an eventual recovery. You can't have a recovery if financial markets collapse, but functioning financial markets can go a long way to helping an economy recover.

It's worth repeating what I said almost a year ago: the losses that result from PIIGS debt defaults have already occurred in an economic sense. Money was essentially flushed down the toilet the moment that Greece borrowed money to support the lifestyle of a bloated and unproductive public sector. Greece never used the money it borrowed for any productive purpose, and so it was eventually unable to repay its debt. It's as simple as that. Spain seems likely to default as well, but that's not as important as the fact that the losses from an eventual default occurred long ago when the money was first borrowed and then wasted on unproductive activities. What we are seeing now is the battle over who is going to have to take responsibility for these losses. The losses have already occurred; the other shoe that is yet to drop is whose balance sheet is going to have to take the hit. More PIIGS defaults are not going to create new economic weakness in the Eurozone, they are simply going to result in a transfer of wealth from those bearing the burden of the loss to the sovereigns being relieved of some or all of their debt burden.

The shareholders of Eurozone banks have already taken an enormous hit, probably absorbing the lion's share of the eventual losses. All Europeans are likely to share in the losses as well, to the extent that central bank liquidity injections result in a weaker Euro and higher inflation in the years to come. The Germans may get pressured to absorb some additional losses if keeping the euro and the Eurozone intact are important to them. Whatever the case, the losses are real and they are water under the bridge. By supplying enough liquidity to keep financial markets liquid, central banks are laying the groundwork for a resolution to the Eurozone crisis and forestalling what would otherwise be a depression/deflation of terrible proportions.

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