Vae Victis - the acceleration in the European turmoil and markets review

April has made a turn for the worse. While we have witnessed a flight to safety with further tightening of German 10 year government debt, for peripheral countries, things have turned sour.

2 Year Greek debt ended April at an incredible 26% yield with 5 year CDS reaching 1350 bps, equating to a cumulated probability of default of around 68%. On the 7th of April, Portugal threw in the towel and asked for help, meanwhile ECB's concerns on inflation was marked by a raised to 1.25% of its key rate.

Greece Sovereign CDS reaching stratospheric levels in April:

Greece is facing a wall of maturity between 2012 and 2015, bond redemptions represent 112 billion Euros. No matter what Georges Papaconstantinou says, a restructuring cannot be avoided. It is already priced in the market. Greece has around 330 billion euros in outstanding bonds.
Greece debt distribution:

Greek bonds deterioration accelerated in April:

Real Estate Market in Greece is falling:

Non-performing loans in Greece surging:

A debt restructuring for Greece, three options:
-Reduction in the coupon
-Extension of the maturity
-Both extension of maturity and extension of the coupon

European Union finance officials, had an unannounced meeting May 6 in Luxembourg. They are trying the help to ease the debt burden. It would be better to deal with the restructuring now than later. The pain inflicted will be larger down the line. They have to stop kicking the can down the road and bite the bullet, time is running out fast.
Luxembourg Prime Minister Jean-Claude Juncker is still trying to avoid it: “We were excluding the restructuring option which is discussed heavily in certain quarters of the financial markets,”. The consequences of the ongoing turmoil affected the Euro which dropped like a stone from 1.49 to 1.43 in a couple of days:

There is a wall of refinancing for Greece but the elephant in the room for Greece in particular, and for some other countries in general, is the issue of unfunded liabilities (Ponzi scheme?):

A clearer picture on unfunded liabilities for Greece, a gigantic problem:

Portugal Sovereign CDS has reached the level of Ireland, the widening has been significant since February:

Following issues relating to the Peripherals in trouble, namely Spain, Portugal and Ireland, Spain, Italy and Belgium widen on Friday according to CMA:

But concerns on Spanish banks in the CDS market have come down since February:

Spain is the last line of defense. The revised ESM in March, in conjunction with the EFSF is enough to ensure proper liquidity issues for Greece, Portugal and Ireland until 2013, but cannot be viewed as resolving the outstanding solvency issues.
Spanish GDP grew 0.2 percent in the 1st quarter, matching 4th Quarter 2010. GDP expanded 0.7 percent from a year earlier according to the Bank of Spain on the 6th of May.
IMF forecast a GDP expansion of 0.8% in 2011, while the central bank forecast the economy will expand 1.5%.
Consumer spending is still weak with record unemployment. Spain has one of the highest private-debt burdens in the euro region. 97 percent of mortgages have variable rates, which mean that further rate hikes from the ECB could potentially have a serious impact on an already fragile economy.

As a reminder (from my post Europe - The end of the Halcyon days, this is the German banks exposure to peripheral debt:

And another reminder, Countries cross border exposure:

Consequences of European turmoil, U.S. two-year note yields dropped on Friday to the lowest level since March. Flight to quality or is it?

In the US:
U.S. added 244,000 jobs according to the NFP published on Friday but unemployment was up, reaching 9% from 8.8 percent in March, the first increase since November.
US GDP growth slowed to 1.8 per cent in the first quarter of 2011: Slowdown, headwinds and headaches...
ISM’s index of non-manufacturing companies fell heavily to 52.8 in April, the lowest since August 2010, from 57.3 in March.
Retail sales rose by 0.6 percent in April, up from 0.4 percent.
Overall we have very mixed data.

Risk of a double dip?
We have a double dip in housing in the US.
Housing is still very weak and still falling in the US. U.S. home prices back down to their 2009 lows according to the S&P Case-Shiller Index for February.
Sales of new single-family houses in March 2011 were at a seasonally adjusted annual rate of 300,000, according to estimates released jointly today by the U.S. Census Bureau and the Department of Housing and Urban Development. This is 11.1 percent (+/-21.7%)* above the revised February rate of 270,000, but is 21.9 percent (+/- 10.3%) below the March 2010 estimate of 384,000. Still very weak.
We have an acceleration in distressed sales in Q1 in the US, as well as falling prices. Economic 101: Higher percentage of distress sales = downward pressure on house prices.

For more on the US weekly summary, the always excellent CalculatedRisk blog:

Summary for Week ending May 6th

Positive news worth tracking for the US:
"New Households Form at Fastest Rate Since ’07 in Resurgent U.S."according to this Bloomberg article.

This is important to track as it will generate positive contribution to GDP.

Good thing about recession (or is it?):
Divorce rates are falling. From the same Bloomberg article:
"The number of divorces dropped to 6.8 per 1,000 people in 2009 from 7.4 in 2006 prior to the recession, according to the National Center for Health Statistics in Hyattsville, Maryland."

Fed and BOE kept rates at the same level in April. The Fed has kept its target rate for overnight lending between banks at zero to 0.25 percent since December 2008.

Commodities update: Pop goes the bubble in conjunction with Glencore's IPO? How ironic.

Silver in a tailspin after an unsound meteoric rise:

Tip for silver or possibly the trade of the year?
How to make 6.3 millions USD profit since April 11 on Silver? Start with a 1 million USD bet:
Would The Silver Medalist Please Stand Up?
"Market watchers want the anonymous April silver bear in listed options to take a bow. The unknown investor's mid-April $1M bet that iShares Silver Trust (SLV) would hit $25 or lower before mid-July is worth more than $7M after this week's plunge. Not just the drop in price, but huge jump in price volatility, has goosed has enriched this trader's options position. "The investor didn't get this trade right. He or she got it spectacularly right."
source Dow Jones.

The big positive for GDP: The drop in Oil prices
2008 Redux?

The WTI contract lost 15.4 per cent from Monday's peak near 115 USD, a level last seen in early September 2008.

Higher resource prices act as a tax and sap consumer disposable income.
Oil prices receding are indeed good news. Commodity prices have been driven to excess by speculators, the correction so far is not due to faltering demand in emerging markets.

What happened to curb the ongoing speculation:
CME futures exchange has increased margin requirements sharply, rapidly and several times. Traders had the choice of putting up more cash for their trades or cash in, taking their profits.

This is a very important lesson to be learned: This shows what can be done by the authorities to pop bubbles.
We all know the common know adage: "Don't fight the Fed". For commodities, here is a new one, don't fight the authorities.

For Silver the bubble has clearly pupped, oil has well, for the moment.

"The fall in the price of oil and commodities is good to take for all reasons, certainly for inflation, not only immediately but with the danger of second-round (effects) in the medium run," ECB President Jean-Claude Trichet declared.

"It is also good to take in terms of consolidating the recovery because any increase in the price of oil and commodities has an inflationary impact and a depressive impact (on growth)," he added.

A welcome respite in the surge in commodities.
We shall see in the coming months if it is just a big pull back like we had in 2008. Let's see how long this one lasts!

The moral hazard mistake of 2003 - The violation of the European Stability Pact

Germany and France violated the Stability Pact on purpose in 2003.

The Stability and Growth Pact (SGP) was an agreement among the 17 members of the European Union to facilitate and maintain the stability of the Economic and Monetary Union.

In order to do so, the actual criteria that member states must respect was the following:

-an annual budget deficit no higher than 3% of GDP (this includes the sum of all public budgets, including municipalities, regions, etc)
-a national debt lower than 60% of GDP or approaching that value.

German finance minister Theo Waigel in the mid 1990s was the proponent of the SGP.

The idea was to limit the ability of governments to exert inflationary pressures on the European economy.

The Council of European Ministers failed to apply sanctions against France and Germany, despite punitive proceedings being started when dealing with Portugal (2002) and Greece (2005), though fines were never applied and the the European Court of Justice later declared that decision invalid.

In March 2005, the EU Council, under the pressure of France and Germany, relaxed even more the rules:

http://en.wikipedia.org/wiki/Stability_and_Growth_Pact

"The Ecofin agreed on a reform of the SGP. The ceilings of 3% for budget deficit and 60% for public debt were maintained, but the decision to declare a country in excessive deficit can now rely on certain parameters: the behaviour of the cyclically adjusted budget, the level of debt, the duration of the slow growth period and the possibility that the deficit is related to productivity-enhancing procedures."

The great idea of German fiscal discipline was betrayed by the Germans themselves creating a dangerous moral hazard which lead us to today's European disaster. I always believed in "leading by example": if you want to be respected as a leader, you need to lead by example.

Would the situation be different today if the German and the French had respected prior engagements relating to fiscal discipline? I certainly think so.

How ironic it is today to see Germany clamoring for fiscal discipline in peripheral European countries when a short time ago, they had betrayed the very idea they stood behind for so many years.

In 2003, Pandora's box was opened, with the consequences we are all witnessing today.

If you look at the period of 2000 until 2003, you will notice countries like Belgium, Ireland, Spain were in fact managing much better their public finances than the likes of France and Germany.

GENERAL GOVERNMENT FINANCIAL BALANCES

(% OF NOMINAL GDP)

2000-06

Source: OECD Economic Outlook 76 database

At the time of the violation of the SGP, peripheral countries like Portugal, Ireland and Austria did complain about the case of double standards, because they were trying to abide to the SGP rules.

What were the dire consequences for the violation of the pact?

The ECB had to step in and follow a tighter monetary policy.
Between 2003 and 2004 it allowed real interest rates in the eurozone to fall to zero. The ECB also abandoned the so-called monetary pillar of its strategy -- "a prudent cross-check that looked at the rate at which money supply was growing". For several years, money growth exceeded the ECB's target rate of growth of 4.5 per cent a year. This equated to overreliance on credit in the Eurozone. It made the Eurozone government fiscal balances overdependent on tax revenues from activities that were based on borrowing, namely housing and construction: hence the housing bust in Spain, Ireland, etc.

The basic premise of the SGP made sense. It could not have been possible to launch the euro without a proper framework to promote financial discipline in a currency union not complemented by full political union. But once again, what lead to the current disaster was the lack of discipline of the politicians.

Back in 2003:
http://www.euractiv.com/en/euro/commission-stays-firm-stability-growth-pact/article-116646

"Commission president Romano Prodi stressed that while 'maximum available flexibility' should be applied, the Commission 'must and will apply the treaty for the common good'. Mr Prodi also expressed doubts that higher deficits would help the EU recover from the economic downturn. This strict stance was welcomed by several smaller eurozone members as well as aspirant countries determined to stick to the pact underpinning the euro."

But we know the story Romano Prodi failed and Germany and France jointly betrayed the SGP in 2003, which lead to the ECB having to step in as explained above.

As Mr. Trichet said recently:

"Monetary-policy responsibility cannot substitute for government irresponsibility".

http://online.wsj.com/article/SB10001424052748704739504576067352757709020.html

"Mr. Trichet continued to dwell on perhaps his biggest policy-related defeat of 2010: the rejection by governments of his demand for strict, automatic sanctions on countries that exceed Europe's budget deficit limits. Under a French-German accord reached in October and backed by other governments, the ultimate decision on sanctions will be left in the hands of political leaders and not be applied automatically."

Until automatic sanctions are set up as recommended by Mr Trichet, politicians will still have the ability to postpone structural reforms (in order to seek re-election...).

"We should be inflexible in applying sanctions if rules are breached," Mr. Trichet said, and penalties should include "fines, reduced access to EU funds, and other pecuniary consequences."

I completely agree with Mr Trichet. Unless sanctions are applied automatically, the European system and the SGP will be abused.

Courage under duress? Don't count on European politicians...