Ben Bernanke’s Fed has embraced inflation and currency debauchment as the way out, but the ECB is not there yet.
That’s why European markets sold off overnight, which then spread to another 500 point debacle on Wall Street. The markets are now gripped by panic about Europe’s failure to act decisively so that the rally sparked by the Fed’s statement on Tuesday has evaporated and reversed.
Unless the Germans allow the ECB to monetise Europe’s sovereign debt, including France’s, their banks are insolvent and there will be another 2008-style credit crisis. The only way out now is a massive global bailout of Europe, followed by debt monetisation and inflation, which will allow default by stealth and force investors to increase risk.
At one stage Societe Generale shares were down 20% last night on rumours that S&P was about to strip France of its AAA credit rating, and they recovered once that was denied. But the German, French, Italian and Spanish stock markets all fell by more than 5 per cent and then Wall Street followed up with a drop of 4.5%, losing all of yesterday’s rally.
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The fundamental problem underlying this new rise of the undead credit crisis is that the world’s corporate classes – managers and owners (investors) – have lost faith in government and the suppliers of bank capital have once again lost faith in the loan books. All are now desperately trying to preserve their capital.
America’s corporations have $US1.1 trillion in cash on their balance sheets, but it’s under lock and key. They are neither employing nor investing.
Investors are moving their money into cash as fast as possible, horrified at the mess that politicians and central bankers have created and are now making worse.
The Fed’s statement on Tuesday, which appeared to produce a turnaround in sentiment, was a deliberate attempt to engineer a bull flattener – that is, the situation where long rates are falling faster than short rates.
By locking in 0-0.25% cash rates for two years, the Fed is inviting the market to push the yield on two-year Treasuries to virtually zero. In response the yield on the 10-year bonds has rallied 11 basis points last night and is approaching the record low of 2% reached in the panic of October 2008.
As the Lex column in the Financial Times pointed out this morning, the Fed is effectively saying that “the key to getting through this rough spot is that everyone calms down, and sees that they have no choice but to buy risky assets.”
No choice, because with the “risk-free” rate way below the inflation rate you are going backwards at a faster and faster rate – it’s an attempt to replace confidence with coercion. However, the fact that gold is now approaching $US1800 an ounce shows that investors aren’t too worried about real returns at the moment – they’re just interested in preserving capital against the privations of government debt, credit squeeze and recession.
All of that has been undermined in just 24 hours because the situation in Europe is swiftly getting away from the authorities. The ECB said this week it was buying Italian and Spanish bonds, which was a watershed moment in some ways, but nowhere near enough.
France and Italy each have about €1.6 trillion in government debt. Germany has even more – about €1.8 trillion (the difference is that its economy is growing reasonably strongly for the moment).
The funding task over the next three years for these countries alone, not to mention Greece, Spain, Portugal and Ireland, is vast and the markets are now closing up on them. A liquidity crisis threatens to become a solvency one for most of Europe.
The only answer is a blitzkrieg of cash (historical reference intended), well beyond the puny resources of European Financial Stability Fund, and probably beyond the ECB – certainly under its existing rules.
Tony Boeckh, the former editor of Bank Credit Analyst, says the EFSF needs to be bolstered by credit swaps of $2 trillion, plus another $2 trillion on standby, provided by “the key central banks of the world, sovereign wealth funds and international financial bodies such as the IMF and BIS.”
Simultaneously, the ECB must announce unlimited purchases of bonds of threatened EU members.
Boeckh says the actions need to be so massive that “markets can only think overkill” and the package needs to be broadly multinational so that markets know the commitment is global and total. In addition, there needs to be increased debt monetisation – “it is essential for central banks to risk eventual inflation, and even encourage it.”
That is what the Federal Reserve is now doing even though it backed off another round of QE, but unless its European counterpart can prevent a panic across the Atlantic, it will be undone.
This article first appeared on Business Spectator.