Saturday, April 18, 2015

Is Mario Draghi Stupid, Crooked Or What?

By David Stockman

Europe is surely at the top of today’s heap of raging  financial market lunacy. It seems that Ireland has now broken into the negative interest rate club, investment grade multinationals are flocking to issue 1% debt on the euro-bond markets and, if yield is your thing, you can get all of 3.72% on the Merrill Lynch euro junk bond index.

That’s right. You can stick your head in a financial meat grinder and what you get for the hazard is essentially pocket change after inflation and taxes.

Remember, the average maturity here is in the range of 7-8 years. During the last ten years Europe’s CPI averaged 2.0% and even during the last three deflationary years the CPI ex-energy averaged 1.2%. So unless you think oil prices are going down forever or that the money printers of the world have abolished inflation once and for all, the real after-tax return on euro junk has now been reduced to something less than a whole number. Has the reckless stretch for “yield” come down to this?

Well, no it hasn’t. Yield is apparently for suckers and retired school marms.

This is all about capital gains and playing momo games in the bond markets. It’s why euro junk debt—-along with every other kind of sovereign and investment grade debt—-is soaring. In a word, bond prices are going up because bond prices are going up. It’s an utterly irrational speculative mania that would do the Dutch tulip bulb punters proud.

In the days shortly before Draghi issued his “whatever it takes” ukase, the Merrill high yield index was trading at 9.0%. So speculators who bought the index then have made a cool 140% gain if they were old-fashioned enough to actually buy the bonds with cash. And they are laughing all the way to their estates in the South of France if their friendly prime broker had arranged to hock them in the repo market even before payment was due. In that case, they’re in the 500% club and just plain giddy.

Does Mario Draghi have a clue that he is destroying price discovery completely? Do the purported adults who run the ECB not see that the entire $20 trillion European bond market is flying blind without any heed to honest price signals and risk considerations at all?

Worse still, do they have an inkling that the soaring price of debt securities has absolutely nothing to do with their macroeconomic mumbo jumbo about “deflation” and “low-flation”?  Or that they are in the midst of a financial mania, not a ” weak rate environment” due to the allegedly “slack” demand for credit in the business and household sectors?

In fact, European financial markets are being stampeded by a herd of front runners who listened to Draghi again yesterday reassure them that come hell or high water, the ECB will buy every qualifying bond in sight at a rate of $65 billion per month until September 2016. Full stop.

Never before has an agency of the state so baldy promised speculators literally trillions in windfall gains by the simple act of buying today what Draghi promises he will be buying tomorrow. And that will be some tomorrow. As more and more sovereign debt sinks into the netherworld of negative yield and falls below the ECB’s floor (-0.2%), there will be less supply eligible for purchase from among the outstanding debt of each nation in the ECB’s capital key.

This is price fixing with a vengeance. It is no wonder that repo rates have plunged into negative territory.

But here’s the thing. The geniuses at the ECB are not cornering the market; they are being cornered by the speculators who are recklessly front-running the central bank with their trigger finger on the sell button. Everything in the European fixed income market is now so wildly over-priced and disconnected from reality that the clueless fools in Frankfurt dare not stop. They dare not even evince a nuance of a doubt.

So this is a house of cards like no other. Greece is a hair from the ejection seat, yet everything is priced as if there is no “redenomination” risk. Likewise, with the European economies still dead in the water, and notwithstanding some short-term data squiggles in the sub-basement of historic trends, the debt of Europe’s mostly bankrupt states is priced as if there is no credit risk anywhere on the continent outside of Greece.

Well then,  just consider three fundamentals that scream out danger ahead. Namely, public debt ratios continue to rise, GDP continues to flat-line, and the Eurozone superstate in Brussels continues to kick the can and bury its member states in bailout commitments that would instantly result in political insurrection in Germany, France and every other major European polity were they ever to be called.
In short, Europe is a financial and political powder keg. The ECB is bluffing a $20 trillion debt market and the Brussels apparatchiks are bluffing 300 million voters.

The only problem is that the true facts of life are so blindly obvious that its only a matter of time before these bluffs are called. And then the furies will break loose.

In the first place, the EU-19 is marching toward the fiscal wall and even Germany’s surpluses cannot hide the obvious. During the last six years, the collective debt-to-GDP ratio among the Eurozone nations has gone from 66% to 91% of GDP, and the sheer drift of current policy momentum will take the ratio over the 100% mark long before the end of the decade.

Historical Data Chart
Secondly, notwithstanding the ebb and flow of short-term indicators, there is no evidence whatsoever that Europe is escaping its no growth rut.  Indeed, euro area industrial output has continued to flat-line, and remains below the level achieved way back in 2002.

You can’t grow your way out of debt on the basis of a profile like that in the graph below. Even then, the underlying truth is more daunting because the picture is flattered by Germany’s exports to China and the EM that are fast coming to a halt.

Eurozone Industrial Production

quick view chart
Thirdly, the state sector in Europe has gotten so big that politics are paralyzed. Accordingly, it is virtually impossible that the true barrier to growth—crushing taxes and interventionist dirigisme—-can be eliminated. Check out recent pro-market policy actions in Italy, France or Spain. There have been none.
Historical Data Chart
So with no growth and rising debt, how long can the Brussels bureaucrats continue to bluff? Yet here is what the EU nations owe on Greece alone.

Source: @FGoria 

Is it possible that France could absorb its $70 billion share and see its 10-year bond remain at today’s 35 bps? Is it likely that Italy’s paralyzed government would last even a day if its $60 billion Greek guarantee were called or that its 10-year bond would trade for even a nanosecond longer at todays 1.25%?

Would not the bombastic crooks who run the Spanish government send a few legions of crusaders into Greece before they made good on the $42 billion they are on the hook for?  Would the bond speculators basking in the Riviera not hit the sell button at the sound of the Spanish hoofs?

So, yes, the euro and the Eurozone do not have a prayer of surviving. It is only a question of when the bluff of a handful of bureaucrats in Brussels and Frankfurt is called.

Maybe Varoufakis will do it next week, or his successor will be forced to after the next Greek election. But whatever the precise scenario, Greece is finished, the bailout commitments will be called, and all hell will break loose in a $20 trillion bond market that is in thrall to a raging central bank induced mania.
In this fraught context, it is tempting to think that Mario Draghi is being paid off by someone. But a project this monumentally stupid may be just that. To wit, the work of a monumentally stupid man.

David Stockman is the former Director of the Office of Management and Budget during part of the Reagan Administration, from 1981 to 1985. He is the author of The Great Deformation: The Corruption of Capitaism in America and The Triumph of Politics: Why the Reagan Revolution Failed.

 The above originally appeared at David Stockman's Contra Corner and is reprinted with permission. 

1 comment:

  1. Perhaps someone can answer (or RW or Stockman write an article) what happens to gold (and silver) when such a scenario happens.

    1) If most assets ( Real Estate / stocks / bonds) go down because there is a liquidity crises ( margins called in / investment tied up, or lost)... will gold go DOWN ?

    2) Or, will people flee fiat currencies, and thus gold go UP?

    3) Or, will gold go initially down, due to liquidity, and THEN slowly go sky high, as people flee to value (and avoid hyperinflation), thus creating a sort of U shaped curve over several months?

    Sidebar: How might the gold to silver ratio, currently at 74:1, be effected?

    Thanks, and always great to read Stockmans insights!