Jean-Claude Trichet, the Party-pooper

Just as the EU's political and bureaucratic classes (note that the two are often indistinguishable in Europe, as many politicians are career bureaucrats) went  into paroxysms of self-congratulation over their allegedly 'historic agreement' on Monday, there came soon outgoing ECB chief Jean-Claude Trichet and poured cold water on the proceedings.


It often happens when a bureaucrat nears retirement (see Thomas Hoenig as an example) that suddenly, he talks more frankly, becomes less economical with the usually unpalatable truth. So it is presumably with Trichet, who it must be said, is anyway both a fairly conservative and outspoken figure as central bankers go. Although we think that not even an evidently well-informed an well-intentioned man such as Trichet can be expected to successfully centrally plan money and although we are convinced that central banks are institutions that are surplus to the market economy's requirements and do invariably more harm than good, we'd rather have Trichet at the helm of a central bank than, say, Eric Rosengren or Dennis Lockhart.

What aroused Trichet's opposition to the deal are its obvious flaws such as the utter lack of enforcement mechanisms that already marred its predecessor versions. It simply doesn't go far enough in his opinion. As the Irish newspaper The Independent reports:


“Finance ministers began this week's talks in Brussels with 10 issues of disagreement, all of which have now been resolved. "This is a little bit of a historic moment," Swedish Finance Minister Anders Borg said yesterday.

Both the ECB and the European Commission had been pushing heavily for sanctions to be "automatic" but the agreed deal gives countries two chances to overturn possible sanctions.

The European Commission's economics chief Olli Rehn said he was "reasonably satisfied with the outcome", which he described as "very close" to the commission's original proposals but the ECB's Mr Trichet said the measures were "insufficient".”


ABC news provided a little more detail (looking at other news sources we found that none of them had any more to say about Trichet's objections, which indicates that his comments were curt. He must have been angry):


“European Union finance ministers on Tuesday tightened rules on public spending limits but the head of the European Central Bank said the agreement did not go far enough to alleviate concerns over the euro.

The bank's president said the stricter rules, which make sanctions for overspending governments more automatic, did not sufficiently learn the lessons from the continent's debt crisis, and called on the European Parliament, which has to approve the final legislation, to make them stricter.”


Trichet is of course also unhappy that the sorry task of buying up the bonds of the de facto insolvent peripheral euro area sovereigns in order to manipulate their yields was once again dumped into the ECB's lap. He was apparently hoping that the ECB would be extricated from this toxic waste collection business, but that was not to be .

He should have known better: the politicians know very well that it is much easier to sweep these bond market manipulation activities under the rug if they are perpetrated via the printing press than if they require subsidies by the nations financing the EFSF. If the borrowers eventually default, then the ECB will have printed a wagon load of money that it can no longer 'drain' and the losses will be borne by every single holder of the euro currency. It would be as if one were stealing one or two euros from every citizen of the euro area. Nobody would notice.

Trichet is of course correct that the agreement will once again prove unenforceable and is therefore as useless as a snooze button on a smoke alarm. Alas, even he still fails to face up to the real problem – namely, that some of the debtors that have provoked the crisis are simply unable to pay their debts. This is the salient fact that no agreement imposing new rules can change. Essentially there are only two possibilities: either the rich 'core' of the euro area really bails them out, or it agrees to a debt restructuring and then ponders whether it should bail out its own over-leveraged banks or let them go bankrupt too.


Now It's Ireland's Turn

As we noted yesterday, Ireland was not rewarded with lower interest rates on its bailout borrowings by the eurocracy, due to its intransigence regarding the demand that it raise its low corporate tax rate. The Irish government was of course perfectly correct in refusing to collaborate on this pernicious attempt to hamper Ireland's competitiveness.

However, the Irish are not without options. As we noted previously, once a country's banking system has collapsed, the 'roach motel' feature that is built into euro membership loses much of its power. Such a country need no longer fear a flight of depositors from its banks, since they have already fled. The Irish know very well that the bailout with its attendant demand that 'no bank bondholder be left behind' has more to do with the exposure of euro area banks to Irish debt than with any desire to help Ireland as such.

As reported by Forbes:


“Ireland's new prime minister declared Tuesday that his country will demand easier bailout terms and expect foreign investors to share in the colossal losses at Irish banks – but will not give in to EU pressure to raise its low business tax.

Enda Kenny – elected one week ago and already at loggerheads with the European Union over the cost of Ireland's loan package – told lawmakers his government would stand tough in its demand for a lower interest bill without conditions.”


“Other European leaders led by French President Nicolas Sarkozy last week directly told Kenny that Ireland must make concessions in exchange for any rate cut. Sarkozy singled out Ireland's low business tax as amounting to unfair competition with higher-tax France and should be raised as part of any new agreement.

But Kenny said Ireland would not permit EU partners to dictate Ireland's tax policies, which have helped to woo 600 U.S. high-tech companies to Ireland.”


“The potential euro 67.5 billion ($92 billion) EU-IMF credit line negotiated by Ireland's previous government commands an average interest rate of 5.8 percent, whereas the funding cost of EU donors averages 2.7 percent.

That profit for EU donors is adding hundreds of millions of euro to Ireland's deficits and long-term debt. Greece, under similar pressures, last weekend did receive a cut of 1 percentage point from its own EU loans.

Last year's Irish deficit reached a modern European record of 32 percent of GDP chiefly because Ireland's previous government committed to protecting its insolvent banks. The deficit is supposed to be slashed to 3 percent by 2015 under terms of the bailout.

Kenny said his government intended to withhold further state funding from five Dublin banks until EU leaders agree on new rules that encourage – or compel – the banks' senior bondholders to start absorbing some losses. EU financial chiefs have repeatedly resisted such calls, arguing that defaults would undermine European banks' ability to keep tapping bond markets.

"It was always unfair to force the Irish taxpayer to fork out 100 percent for the consequences of reckless banking," Kenny said, criticizing the previous government's decision to guarantee all debt obligations of Irish banks. The policy has meant Ireland has nationalized or taken major stakes in five banks at a cost topping euro50 billion ($70 billion).

The new deputy prime minister, Eamon Gilmore, added that Ireland was committed to "tearing up the blank-check policy on banking that has undermined our very sovereignty.”


(our emphasis)

As can be seen from the highlighted sections above, the crux is that the high tax countries – instead of restoring their competitiveness by lowering taxes – want to force others to raise theirs. This is the greatest danger posed by the crisis – namely that the 'tax harmonizers' will eventually get their way. Statism is France's and Germany's main religion and they seek to impose it on everyone.

However, Irish prime minster Kenny has correctly analyzed the situation and evidently realized that he can now wave the bigger stick. By withholding funding from Ireland's insolvent banks, he will likely be able to force the EU into giving Ireland the concessions it demands. If the other euro-area members try to 'get tough' on Ireland, it could precipitate a new banking crisis across the EU, which would hit the banks of the 'core' nations the hardest, since they have the highest leverage and biggest exposure to dodgy debt. Ireland would do well to insist that the bondholders of its insolvent banks share in the losses. In fact, Irish tax payers should never have been asked to fork over a single red cent. Why should the rules of free market capitalism be suspended for the sake of bank bondholders? Yes, it would certainly 'undermine European banks' ability to keep tapping the bond markets' if they had to admit to the losses that are rightfully theirs. So what? They should not have speculated in Ireland's property bubble by financing Ireland's banks in the first place. Ireland's tax payers never asked them to do so.

Moreover, bank managers who were seduced into participating in the bubble  have proved their incompetence beyond a shadow of doubt. Anyone with even a shred of common sense could see that this bubble would eventually blow up. One would think that highly paid bank managers should have been able to recognize this as well and act accordingly. Instead, they decided to forgo their fiduciary duty in favor of the pursuit of ephemeral short term bubble profits – convinced that governments would surely bail them out if things went wrong. This preposterous combination of insolence and incompetence has not produced any adverse consequences for them – as they were quite correct about at least one thing: tax payers were forced to bail them out. Perhaps some belated justice will be administered now.

Ireland should indeed 'tear up the blank-check policy on banking'  someone has to do it, if only to slightly lower the probability that yet another boom-bust cycle consumes what little capital is left after the last one.


Portugal's Debt Crisis Deepens

Late on Tuesday, Portugal's debt was once again downgraded by Moody's (by two notches this time), and its bond yields consequently continue to shoot up. Concurrently, a political crisis is beginning to undermine Portugal's austerity policy – which is precisely the type of development we keep warning about. The austerity plans may make sense on paper, but in the real world, voters just won't stand for them. Today's bond auction went poorly as a result, and Portugal's government now warns that a bailout may be inevitable (of course it always was inevitable). According to Bloomberg:


Portugal's government blamed higher rates paid at a debt auction on Wednesday on the opposition's refusal to back its latest austerity plans, warning a political standoff could force it to seek a bailout.

Pressure on Lisbon mounted after Moody's credit rating agency downgraded Portugal by two notches late on Tuesday, highlighting the challenges it faces it in riding out its debt crisis. The yield on 1 billion euros ($1.40 billion) of 12-month treasury bills rose to 4.331 percent at the auction, compared with 4.057 percent two weeks ago.”


“The worsening financing situation for Portugal — which many economists say is the next likely euro zone country to need a bailout after Greece and Ireland — suggests the deal by euro zone leaders at the weekend to boost their rescue fund may have come too late for it.

Since then Portugal's plight has become yet more complicated by the fact that the main opposition Social Democrats have refused to back the government's latest austerity plans, which are aimed to ensure the country meets its budget goals.

"Failure to approve the new measures in the budget plan would push the country to external help," Finance Minister Fernando Teixeira dos Santos told parliament's budget committee. "Current market conditions are unsustainable in the medium- and long-term."

Prime Minister Jose Socrates warned on Tuesday that his minority government would be unable to continue if the country's long-term economic strategy, which includes the latest austerity measures, was not passed in parliament.

"Yield levels in Portugal still trade above their snowball level – where the level of interest charged means their level of debt stock is going up – and that means that longer-term the situation, despite their best efforts is getting worse not better," said rate strategist Charles Diebel at Lloyds Bank.”


In our opinion it's all over but the shouting. Portugal was always destined to require a bailout, and now the time has evidently come where it is truly unavoidable. For a long time the government tried to keep its fiscal sovereignty  intact by accepting the high interest rates the market currently imposes, but the fact of the matter is that it can not possibly afford them.

Once Portugal becomes a ward of the EFSF as well, we suspect the market will once again begin to worry about Spain,  even though perceptions on Spain have recently improved. We believe however that Spain's post-bubble problems are much bigger than is currently thought. It has merely been more successful in pursuing an 'extend and pretend' strategy. Of course Spain's economy is far larger than the economies of the peripheral countries that have so far required assistance from the EFSF. That fact alone gives it more flexibility in handling the crisis – nevertheless, the problems faced by its banking industry are likely still growing. This is simply due to the 'stickiness' of real estate cycles. As we have seen in Japan, once a major real estate bubble falters, the subsequent denouement can play out over many years.  The 'extend and pretend' policy of keeping unsound credit on artificial life support in the hope that things will get better over time is bound to fail in such long term price adjustment cycles. The question is: Why should it be different in Spain? 

The Charts:


1.    CDS (prices in basis points, color coded)


5 year CDS spreads on Portugal, Italy, Greece and Spain – The quick tightening of Greece's CDS spreads following the concessions on its bailout credit interest rate has already been partially taken back. The market evidently still doesn't believe Greece will escape its woes without a debt restructuring – click for higher resolution.


5 year CDS spreads on Ireland, the senior debt of Bank of Ireland, France and Japan. Not surprisingly, CDS on JGBs continue to soar in the face of the worsening crisis at the Fukushima nuclear plant following the devastating earthquake and tsunami in Japan. This may be an early warning sign that the tranquility in the JGB market may be about to come to an end – click for higher resolution.



5 year CDS spreads on Austria, Hungary, Belgium and Romania – all still trending lower – click for higher resolution.



The Markit SovX index of CDS on 19 Western European sovereigns – coming back in a bit, but this index remains very high and there is as of yet no sign that its uptrend is in danger, in spite of the fact that the market has lately begun to become a bit more discerning and correlations have lessened – click for higher resolution.



2.    Other Charts



5 year CDS spreads on Australia's 'Big Four' banks – the recent bounce continues, but no major move yet – click for higher resolution.



5 year CDS spreads on Saudi Arabia, Bahrain, Qatar and Morocco. A huge jump in CDS on Bahrain, following the declaration of martial law there and an invasion of Saudi troops – click for higher resolution.




The SPX, T.R.'s proprietary VIX-based volatility indicator, and the gold-silver and gold-commodities ratios. As we have frequently pointed in recent weeks, stock market risk has become very high. The various divergences we took note of previously have now become full-blown sell signals – click for higher resolution.



Addendum – Stocks, Bahrain, Japan and the FOMC


1.    The Stock Market:

Anecdotal evidence suggests that  many shorts have covered their positions yesterday – mainly because they were early in putting them on and finally had a small profit or were back to breakeven. This strikes us as a bearish development for the stock market, which continues to decline as we write this. Sentiment data are not yet indicative of a durable low having been reached.  Furthermore, the fundamental backdrop continues to be very worrisome, in spite of a strong rebound in Japanese equities overnight.


2.    Bahrain

Martial law was imposed in Bahrain and Saudi troops have invaded the island to 'help restore order'. This is a situation that clearly has the potential to escalate further. There have been no signs that Bahrain's opposition will take this incursion lying down. The curfew that was immediately imposed following the declaration of martial law has so far not kept people from continuing their protests.


3.    Japan

Moreover, there are still no good news from the Fukushima nuclear plant in Japan, except for the fact that is has not yet blown up. An attempt to douse the reactors with the help of helicopters had to be abandoned due to a spike in radiation near the plant. We have the greatest admiration for the courage of these men and women, as they are likely about to give their lives for their fellow citizens in Japan.

Nevertheless, it remains highly uncertain whether a full-scale meltdown can be averted, and there are signs that both Unit 2 and Unit 3 of the plant are in critical condition. Reportedly new fires have also broken out.


4.    The FOMC decision

There is not much one can say to yesterday's FOMC statement, which was an almost exact copy of the last one. The only thing that struck us and many other observers as odd was that Japan's plight was not mentioned in it at all.  However, in spite of the rebound of the Nikkei, the disaster in Japan is highly likely to severely disrupt the world's 'just in time' supply chains. Many production processes outside of Japan will be hampered due to a lack of spare parts. Japan is a major supplier of the electronics and car industries for example. We believe that the potential for disruptions that manufacturing industries across the globe are likely to suffer as a consequence of the tragedy that has befallen Japan is still underestimated by most observers. We will have more to say about that point in a follow-up post.


Charts by: Bloomberg



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