The EFSF Debate Sharpens

Since it has emerged after the G-20 meeting that the euro area's political leadership is seriously considering leveraging the EFSF via the ECB or some other mechanism (frankly, the ECB seems the most likely choice), the usual cacophony of squabbling, affirmations and denials has begun to emanate from Europe.

In Germany, arguably the lynchpin to any such plans, the debate has become more rancorous, as politicians on all sides seek to gain advantage from the government's perceived mishandling of the crisis, with even the chairman of the constitutional court, Andreas Vosskuhle (correctly spelled: Voßkuhle) now weighing in. In particular, several members of the sinking ship, the FDP, are saying that they will not vote for ratification of the July agreement unless they are credibly assured that no EFSF leveraging will occur. Vosskuhle meanwhile opines that if Germany is planning to cede more of its fiscal sovereignty to Europe, then it must amend its constitution – a clear signal that the court will no longer just rubber-stamp the government's bailout escapades. Vosskuhle even insists that it will not be enough to alter the constitution via an act of parliament: instead, he demands a referendum. This is bad news for the eurocrats, as a referendum will without a doubt prove a lost cause for them.

Note in this context that when Angela Merkel was asked in her otherwise quite successful television interview over the weekend whether she would (paraphrasing) 'pursue the European idea even if Germany's populace no longer supported it', she gave a quite peculiar answer – essentially it boiled down to 'yes, she would, as Germany profits immensely from European integration even if the people are at present blind to this fact'.

It seems Vosskuhle's remarks are intended as a reminder that this attitude won't fly in Karlsruhe.  A summary of the situation can be read at the Telegraph. Here is a pertinent snip:

“The accusation that German leaders are conspiring with EU officials to emasculate the Bundestag is highly sensitive, going to the core of the raging debate in recent months over EU encroachments on German democracy.

Dr. Vosskuhle said that the improvisation of far-reaching policies had become "dangerous", and warned against schemes to circumvent the rule of law with backroom deals. "Germany has a great affinity for the rule of law. People expect the political class to obey the rules."  He reminded leaders that the court had set clear boundaries to EU bail-outs in a ruling earlier this month, although it gave the go-ahead for the package of measures agreed so far.

"Our judgment makes clear that the Bundestag cannot abdicate its fiscal responsibilities to other actors. And no permanent mechanism may be created that entails taking over the liabilities of other states," he said. When asked whether eurobonds are off limits, Dr Vosskuhle said any ruling by the judges would be "pretty clear".

Ewald Nowotny, Austria's central bank governor, said it would be a grave error for Europe to try to bounce Germany into decision of huge scope and significance without the assent of the people.  "It is quite dangerous when a feeling builds up in Germany that the country is being overrun, and specifically, that such an important country is being outvoted in the ECB," he told Der Standard.

There is little doubt that Chancellor Merkel can pass the EFSF bill with the help of the Social Democrats and Greens. It is less clear whether she can survive the vote without an absolute majority from her own coalition. Green leader Jurgen Trittin said her government would be "finished" if it has to rely on opposition votes.  Her task has become that much harder after Standard & Poor's hinted Germany itself might loose its AAA rating if the rescue machinery is greatly expanded.

"There is no cheap, risk-free leveraging option for the EFSF any more," said David Beers, S&P's head of sovereign ratings. "We're getting to a point where the guarantee approach .. is running out of road," he said, adding the various options under discussion could have "potential credit implications".  The Social Democrats are using their political leverage over the EFSF vote to push for greater "haircuts" for banks holding Greek debt. This creates a fresh set of dangers.”


(emphasis added)

Elsewhere, the Telegraph reports on the impending split in Germany's ruling coalition as a result of the latest EFSF plans:

“Confirmation of the talks, however, sparked outrage in Germany, where opposition politicians threatened to derail the plans by voting against a key amendment to the bail-out fund this Thursday.” […]

“On Thursday, the German parliament is expected to vote through reforms to the EFSF agreed on July 21 to make it more flexible. However, the latest revelations have redoubled opposition efforts.

Social Democrat Carsten Schneider said the government should come clean on its "real intentions" and that "the parliament and public are having the wool pulled over their eyes".

Of course Mr. Schneider's own party would not hesitate for one second to 'pull the wool over the public's eyes' if it were in power. Alas, there is now not only the danger that Mrs. Merkel may lose the support of her own coalition partner, she may even lose the support of the opposition in terms of approval for the EFSF. One thing is clear: if she can not get a majority of her own coalition to vote in favor, her government will fall and new elections will have to be called.

Adding to the sense that there is no clear line in terms of how the EFSF may be  abused in the future to create some European version of 'TARP' or 'TALF', Austria's representative to the ECB board, Ewald Novotny, confirmed that  an increase of the EFSF's firepower was being discussed, while concurrently, both Wolgang Schäuble and Spain's minister of finance Elena Salgado came out to cast further doubts on the plan, respectively to even deny that there were any such plan being considered.


We are just now discussing an extension of this EFSF," European Central Bank Governing Council member Ewald Nowotny said at Harvard University in Cambridge, Massachusetts.

"It is something more than it is now" but "might not be a trillion (euros)," Nowotny said. Markets chatter recently has suggested the fund could be increased to as much as 2 trillion euros from the current 440 billion euros.

Still, in Berlin earlier, Germany's Finance Minister Wolfgang Schaeuble cast doubt on any plan to top up the EFSF.

In his remarks at Harvard Novotny did not repeat comments made earlier on Monday in an interview with Market News International, that ECB rate cuts should not be ruled out. "The ECB never pre-commits, and rate cuts can not be excluded," Nowotny, who also heads the Austrian National Bank, told MNI, adding that the ECB could further downgrade its European grown forecasts.


(emphasis added)


German Finance Minister Wolfgang Schaeuble has rejected reports that the European Union and the International Monetary Fund (IMF) are working on plans to boost the size of the euro zone's financial rescue fund to support a partial debt default by Greece. 

The German government is working together with its European partners to create the conditions for efficient use of the European Financial Stability Facility (EFSF), "but we have no intention to further replenish it," he said in a TV interview on Monday evening.

He made those remarks after reports from the weekend meting of the IMF and the World Bank in Washington of a possible increase in the size of the EFSF to around 2 trillion euros from the present level of 780 billion euros caused new tension in Chancellor Angela Merkel's increasingly shaky coalition. 

Merkel's junior coalition partner, the Free Democratic Party (FDP), threatened to bring down the government by denying it their votes in a crucial parliamentary vote on the euro zone bailout fund on Thursday if any changes are planned.”


(emphasis added)

From this is not quite clear whether Schäuble merely intends to calm his junior partners in the coalition or if he has really declared the plan DOA.

Spain's Salgado:

An extension of the European Financial Stability Facility to 2 trillion euros ($2.7 trillion) as speculated about by markets is not on the table, Spanish Economy Minister Elena Salgado said on Tuesday.  "It is not on the table, nor has it been discussed," she said in an interview on Spanish television.”


(emphasis added)

In other words, things are once again clear as mud in euro-land. You really couldn't make this up. As always happens when the social mood darkens and a major economic contraction accompanied by a secular bear market in stocks is underway, harmony and cooperation are giving way to discord and hostility. Since the current downturn is one of major degree – an attempt to correct the excesses piled up after four decades of an unprecedented global experiment in employing fiat money – we suspect that both the end of the euro and the end of the EU such as it is now constituted are probably not too far away. There may be a final push to try and hold things together, but the writing is clearly on the wall.


Financial Market Reaction

Meanwhile, the action in financial markets continues to reflect growing hopes that something will be done. Mind, there is no let-up whatsoever yet in the credit markets, as evidenced by continued increases in CDS spreads and no discernible recent improvement in euro-land government bond yields of the suspect peripherals and their bigger cousins.

Alas, stock markets have begun to rise, and the major sell-off in commodities appears to have found at least a temporary bottom. Given the fluidity of the situation, it is impossible to tell whether this will lead to a bigger recovery or if it just another one or two day wonder. However, as we have pointed out last week, there are some subtle signs from intra-  and inter-market divergences in the stock market that suggest that the markets are working on building some sort of low. This neither precludes further short term weakness, not can it be ruled out that the divergences are already significant enough to lead to a multi-week rebound. As we have mentioned on Friday, there should be a short term cycle turn in late September, so a bigger bounce can not be ruled out. Stock markets in Asia and Europe are quite buoyant at the time of writing, so perhaps  a more sizable rebound is indeed in the cards.

Note here that the markets do have a few things to look forward to that can be  filed as near certainties at this time. One is the upcoming rate cut by the ECB. Even though the 'ECB doesn't pre-commit' as Mr. Novotny put it, there can be little doubt that it is already so committed in view of the recent sharp deterioration in economic data and the downturn in raw materials prices.

In addition, we think it is now almost certain that the Bank of England will embark on another iteration of 'QE'. It may even lower its benchmark rate further, from the current 0.5% to 0.25%. Serial money printer and chief interventionist Adam Posen's opinions will likely carry the day, and the decision is widely expected by November at the latest.

Moreover, we believe that central banks in emerging markets, including quite possibly China, are on the verge of implementing easier monetary policies as well. We had a first taste of this when Brazil's central bank cut its benchmark interest rate by 0.5% (to everyone's surprise). In China, the banking system is  faced with an ever more severe cash crunch as Mish reports here. This is confirmed by the extreme volatility and still very high level of SHIBOR (the Shanghai Interbank Offered Rate). China's banks are losing deposits to the 'shadow lending system' (essentially giant loan shark operations), where much higher rates are offered than depositors get at the banks. Property developers are with their backs to the wall, as property prices have begun to fall, local governments are in financial difficulties and a multitude of developments stands unfinished – a typical case of a malinvestment boom coming to its end. Note here that the practice of desperate borrowing from loan sharks at usurious interest rates looks like a phenomenon that goes hand in hand with the tail end of such a boom. Developers are scrambling to get hold of a share of the dwindling pool of resources to finish projects for which not enough resources are in fact available.

In summary, markets are anticipating concerted action to ease monetary policy across the globe. Combined with an unwinding of increasingly bearish short term sentiment, this could bring about a period during which the 'hope trade' is put on – a trade based on the 'potent directors fallacy' – in this case the misguided belief that central banks have things under control.

At the same time, we must once again stress that the short term situation remains, as we have put it above, 'fluid'. For instance, Thursday's rally once again occurred on diminishing trading volume, and tech stocks only reluctantly participated. There remains therefore considerable danger even in the short term, as the recent bounce may well have been only a final attempt to defend what is rather flimsy support before a final leg lower is embarked upon. We will soon know which way the cookie will crumble in the short term, but would note that even in the event of a sell-off to lower lows, the moment when a more durable rebound will begin is clearly drawing closer.



The SPX rebounds from the vicinity of its August lows. This may have been a successful 'retest' that brings about a more durable rebound, but we caution that the rally happened once again on declining volume and the technology sector only participated reluctantly – click for higher resolution.



The NDX rallied only a little bit on Thursday – however, the major divergence it has created by putting in a much higher low stands as a warning that the stock market may be about to embark on a bigger rebound – click for higher resolution.



The DJ Industrial Average (INDU) has also rebounded after testing its August low. Compare this chart to the next one – click for higher resolution.



Contrary to the SPX and the INDU, the DJ Transportation Average has put in a lower low before rebounding. Once again, the rebound is marred by declining volume, but the lower low as such constitutes a small bullish divergence in this case (essentially it is the opposite of the higher high seen in early July) – click for higher resolution.



Germany's DAX index. The most recent rebound has slightly altered the technical picture by coming close to negating the 'running correction' pattern. A rally over the resistance at 5,600 is required to confirm this, so the short term path is still not certain. Conversely, a close below the 5,000 level would be confirmation that the decline is going to continue right away, quite possibly targeting the lows made in early 2009 – click for higher resolution.



The same holds for Italy's MIB. Running correction, or bullish wedge, that is the question that will soon be answered decisively. In this case a break above the 15,000-15,500 level would confirm that a short term bullish outcome should be expected, while a close below 13,100 would indicate the decline has further to go – click for higher resolution.



The gold and silver markets threw a proper scare into market participants in overnight trading in Asia on Monday. As can be seen in the below chart, trading volume in gold futures was unusually large for a GLOBEX overnight session. Many speculative long positions were cleared out in the process, and the market recovered smartly from its overnight lows, leaving an inverted hammer candle on the daily chart in its wake.



A close-up of the Sunday-Monday overnight session in the December gold futures contract.  Note the impressive volume spike at and around the low point – this is rarely seen in GLOBEX overnight trading – click for higher resolution.


Gold, daily chart – a large inverted hammer candle has been left in the wake of an overnight test of the 200 day moving average. The gold contract closed at a large daily loss, but way above its intra-night lows. We suspect that the gold price chart is going to build a triangle over time – only a much larger one than we anticipated previously. Once again, trading volume was enormous – recall our previous volume studies in this context. In gold large volume declines tend to 'clear the deck', as leveraged long positions are taken out – click for higher resolution.



In Monday's update on gold, we noted that the firmness in gold's real price meant that the market had punished the stocks of gold producers too severely. In spite of another big decline in the gold price on Thursday, the shares of gold producers actually rallied quite smartly, even though the rally was an 'uneven' affair. Note though that it is normal for the shares of senior producers to move first, with juniors and explorers following later. The green solid line at the bottom is the HUI-gold ratio, which has now  also put in a higher low – click for higher resolution.



Silver has visited the lower end of the support shelf we penciled in on the chart in Monday's update. From there is has likewise produced a large inverted hammer candle. Note that there has been a slight dip in the gold-silver ratio, possibly an indication that a bigger rebound is in store – click for higher resolution.



Euro Area Credit Market Charts

Below is our usual collection of charts of CDS spreads, bond yields,  euro basis swaps and a number of other charts as of Monday's close. Prices in basis points, with both prices and price scales color-coded where applicable. As can be seen, CDS on Greece jumped by about 900 basis points to a new all time high of over 6,700 basis points. The market evidently has very little faith in the assurances of Greek finance minister Evangelos Venizelos.

Meanwhile, CDS on other euro area peripherals and CEE nations continued to rise, while our proprietary index of CDS on euro area banks pulled back further, likely on account of hopes that a big bailout is in the works.

Australia's banks were not so lucky and saw CDS on their debt rise further.



5 year CDS on Portugal, Italy, Greece and Spain Both Greece and Portugal see new record highs, while CDS on Italy and Spain pull back – click for higher resolution.



5 year CDS on Ireland, France, Belgium and Japan – slight pullbacks in this group – click for higher resolution.



5 year CDS on Bulgaria, Croatia, Hungary and Austria – these are all at new highs – click for higher resolution.



5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – all moving to new highs as well – click for higher resolution.



5 year CDS on Romania, Poland, Slovakia and Estonia – slightly higher than on Friday – click for higher resolution.



5 year CDS on Saudi Arabia, Bahrain, Morocco and Turkey – all moving a little higher – click for higher resolution.



10 year government bond yields of Italy and Austria, UK Gilts and the Greek 2 year note.  The rise in 'safe haven' yields supports the idea that risk assets could bounce for a little while. Alas, it is not yet big enough to truly confirm this thesis – click for higher resolution.



Three month, one year and five year euro basis swaps – the small bounce continues (and remains small) – click for higher resolution.



Our proprietary unweighted index of 5 year CDS of eight major European banks (BBVA, Banca Monte dei Paschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito). This index has also pulled back considerably on Monday, as hopes for another bank recapitalization/bailout begin to solidify following the G-20 meeting. However, the pullback is too slight to be truly meaningful as of yet – click for higher resolution.



Inflation-adjusted yields were still declining as of Monday – click for higher resolution.



5 year CDS on Australia's 'Big Four' banks  continue to increase – click for higher resolution.


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