Debt Auctions in Spain and Italy to Test the Waters
Good day… Yesterday went pretty much as expected for yours truly, as I ran from one meeting to another from the time I pressed the send button on the Pfennig until I shut things down and turned out the lights on my way out the door. I barely had time to look at the markets, but from the looks of things I really didn’t miss much. The dollar stayed in a very tight range yesterday and even the precious metals were a bit more subdued with gold staying within a $7 trading range.
The euro (EUR) did shift slightly lower in early European trading after the release of reports showing that sentiment in Europe’s leading economies was unchanged. German consumer confidence measured by GfK SE was predicted to hold steady in October, matching the median forecast in a Bloomberg survey. French business confidence, as reported by the national statistics office in Paris, was unchanged at a reading of 90. Both Spain and Italy will be auctioning bonds this morning, with Italy scheduled to sell 5.5 billion euros’ worth of inflation-linked bonds and Spain will sell as much as 4 billion euros’ worth of short-term bills. Early indications are that both of these auctions will go well as demand for these short-term and inflation-linked obligations is good.
But while the debt auctions probably won’t be a drag on the euro, bickering among European leaders could weigh on the common currency. Spanish leaders have not officially asked for a rescue, fearing the conditions which would be attached to any bail-out plan. And their fears seem justified as Greece continues to struggle to meet the requirements set out to receive their next round of funding. And the storm clouds over Italy continue to darken as the government was forced to sharply raise their budget deficit projections after growth forecasts now project a 2.4% contraction in 2012, double the previous estimates.
The Group of 20 finance ministers and central bankers met in Mexico City on Sunday and Monday and released a statement following the meeting. The G20 officials said the steps taken by central banks to stimulate their economies are not enough, and governments should increase efforts to boost growth. I don’t think Bernanke or Draghi would argue the point, as it is pretty obvious the central banks have run out of ways to boost their economies.
But the bond buying by the ECB was never meant to be stimulative. No, the ECB’s plan to purchase bonds was meant to stabilize the bond markets in troubled countries. As I pointed out in a past Pfennig, this is the biggest difference between what the ECB has announced and the stimulative efforts by the US Fed and Bank of Japan. The Fed and BOJ are attempting to generate growth through keeping their interest rates at very low levels. The ECB plan is designed to counter bond ‘vigilantes’ who drive interest rates on sovereign debt to levels which are harmful to the nations that have issued the debt.
The difference may seem like semantics, but it is an important one. The ECB plan has worked (for now), and the effects can be directly measured by looking at the market interest rates on sovereign debt. Both Spain and Italy will be issuing debt today, and it will be interesting to see how these debt auctions go. In the past, bond traders would stay away from the market, or even sell the bonds short in order to cause panic and drive rates even higher. Then they would purchase the bonds back at cheaper prices, using cheaper euros as the panic would force the common currency to lose value. But with the ECB providing a backstop to the debt markets, these bond investors are less likely to try and game the system. And the most interesting part of the new ECB bond plan is that the ESM still hasn’t even been asked to participate in the bond markets. The new ‘unlimited’ funding plan hasn’t been put to the test, as Spain continues to drag its feet in asking for a rescue. And a successful bond auction in Spain and Italy this morning would enable them to delay any rescue decision for a while longer.
But unlike the ECB’s bond buying plan, the results of the Fed and BOJ’s stimulus programs are not as easily measured. Interest rates are already being held at record low levels, and therefore the impact of pushing billions more liquidity into these markets is harder to quantify. I included a slide of Bernanke quotes during my presentations last week, and the one which got the biggest reaction was the one where he admits the latest round of stimulus probably won’t work. So Bernanke himself doesn’t think the extra liquidity will solve our problems; but why then did he vote for the extra stimulus? I think it is obvious, Bernanke felt pressure to do something as the US economy is just muddling along. The administration has got to be able to tell the public they are doing something to help the economy, whether it has any immediate impact or not.
The trouble with the BOJ and FOMC plans is that while they have little impact on the economies in the short run, they will definitely have a negative impact in the long run. The additional debt which is being created in order to fund all of this fresh liquidity is piling on top of existing debt burdens. With interest rates at current levels, servicing this debt is not a massive problem. But as interest rates increase (and believe me they will increase) the interest expense on all of this debt will become more of a burden. So just as the economy seems to turn a corner and begin to grow, our debt obligations will rise and take a larger chunk out of our budget, either forcing more spending cuts, forcing increased taxes, or (most likely) forcing the printing of more dollars allowing us to pay down the debt with cheaper dollars. Inflation is coming; I really don’t think there is any question about it. Not to sound alarmist, but with the record amount of stimulus being pumped into the markets, I just don’t see how there is any other possible result.
And another result of all of this liquidity being pumped into the markets by the Big 3 of the US, Europe, and Japan? We could see another round of ‘currency wars’ as investors continue to search for yield. As the world’s largest developed nations devalue their currencies with new stimulus, emerging markets have to prepare to see a new influx of capital. Countries like Brazil are preparing for a fresh round of speculative currency flows, and have tried to make their country as ‘unattractive’ as possible with rate cuts and taxes on speculative flows. I imagine we will continue to see some of these emerging market economies take steps to try and prevent ‘hot’ money from entering their markets, but the success of these steps is still questionable. With interest rates remaining at very low levels in the US, Europe, and Japan, I would look for a reemergence of the ‘carry trade’. This should cause the value of the currencies with the highest underlying ‘real’ interest rates to outperform all others.
Currently Mexico has some of the highest real rates, and by no coincidence it is also the best performing currency (MXN) versus the US dollar this year. The second best performer vs. the US dollar? The New Zealand dollar (NZD) is up just over 6% during 2012, another indication that investors are searching out higher interest rates.
The kiwi was boosted overnight by a report in China that showed the leading economic index rose 1.7% in August. The index, which is compiled by the Conference Board in Beijing, showed a big increase over July’s reading of just a 0.6% increase. This data flies in the face of other recent reports, which indicated China was in for a hard landing. All of the commodity currencies have come under selling pressure with worries concerning China’s growth prospects, but this latest data may start to calm some of these fears of a dramatic fall in China. We have long thought the ‘hard landing’ talk was overblown, and continue to expect China to lead the global growth in the coming years. China’s central bank is certainly doing all they can to stimulate their economy, joining both the BOJ and US Fed by adding $46 billion of liquidity into their markets through reverse repo agreements. Chinese leaders have also announced another round of infrastructure building, which has a direct impact on the Chinese economy. I continue to believe that the reports of China’s death have been greatly exaggerated (to steal a quote from Mark Twain).
The commodities, like currencies, were fairly flat over the past 24 hours with both gold and silver trading in a very tight range. Nothing really to report here.
To recap… The euro dropped after consumer sentiment in Germany and France remained static. Auctions in Italy and Spain will test the ECB’s new plan. I spent a lot of time comparing the central bank plans, and worry that all of this stimulus will certainly lead to INFLATION. The stimulus could lead to a return of the carry trade, which should benefit the high-yielding currencies. And data released today shows ‘reports of China’s death have been greatly exaggerated’. Finally, the precious metals remain in a very tight trading range.