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John Taylor On A Schizophrenic Europe – A Must Read

  
  Education
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John Taylor’s most brilliant letter to date.

MARKET INSIGHT REPORT
Schizophrenic Europe
June 10, 2010
By John R. Taylor, Jr.
Chief Investment Officer

Managing an investment portfolio in Europe can put you on the fast track to a mental asylum. Only a playwright like Luigi Pirandello, who lived with a schizophrenic wife and wrote plays like Henry IV with its multiple levels of reality, could cope with the financial landscape in today’s Europe. Unfortunately, with the powerful political elite so committed to the EMU process, which they see as critical to the survival of the European Union, these economic distortions will only become more severe. Eventually it will either end badly, as in Henry IV with violence and death, or well, as in a crucible-like reordering and re-characterization of the European nation states. I expect to be writing about this fascinating process for the rest of my life – and I hope to live a long time.

Differences within the Eurozone are extreme. Ireland saw its nominal GDP drop by 10.2% last year, a decline similar to those experienced in the Great Depression, while the German economy recently grew at a nominal rate above 3%. An independent economist calculated that the value of the euro would have to be $0.31 to balance Greece’s international position, and the number for Spain was $0.34, while Germany could effectively compete in the international marketplace with a euro over $1.80. Despite the ECB pegging the refinancing rate at 1.00%, two-year benchmark government rates for Germany are way below that at 0.48%, but way above it at 7.91% for Greece, Ireland 3.37%, and 3.20% for Spain. Ireland has been living with annual deflation for the last 16 months, while German lawmakers are worried about inflation. These differences have become more dramatic in the past few months and most independent observers forecast that trend to continue. By any economist’s measure this is not an optimal currency zone. But the economists are not in charge, the politicians are, and these politicians have spent their entire careers following their conception of the European currency. Their reputations and the European myth depend on the survival of the euro, and those who doubt its viability are enemies who deserve to be ground into dust. There is one overarching problem that the defenders of the euro cannot overcome: in its current form, the euro’s survival is economically impossible. Prior to the Greek crisis, the market did not understand this, but now it does. And you cannot put the genie back in the bottle.

If part of the euro is worth $1.80 and another part is worth $0.31, how do you value this currency today, while it’s still in one piece? That is the crux of the matter. The uncertainty around this issue is what has caused billions of euros to flee into the security of the Swiss franc. The Swiss authorities have intervened, buying so many euros that their reserves expanded by 45% of their GDP since the start of this year. Despite that massive intervention, the Swiss franc has climbed by 10% against the euro since mid-December. There is no sign of change. As the politicians are completely in control, the schizophrenic euro could go on for years with the economic dislocations becoming more and more intense. Little explosions are likely. Certainly, the Swiss are in a terrible position (see Switzerland Surrounded Again, April 29, 2010) as the euros will keep flowing in. The Swiss franc might gain another 10%, destroying its export base, but the Swiss could change the rules to protect themselves. Although the European political elites are totally committed to the euro, the man on the street is different. The European political peace is a compromise between entrenched elites and the highly entitled masses first formulated by Bismarck over 120 years ago. The withdrawal of those entitlements in order to save the euro could easily upset this historic deal. If those in power continue to ignore the needs of the people, neither the euro nor the current political structure will survive in its current form.

With $1 Trillion In Loans, The ECB Is The Biggest Guarantor Of European Banks

  
Analysis, Economy, Education
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Today’s lower than expected interest in the 3-month LTRO operation was supposed to indicate a sign of stability for European banks. Nothing could be further from the truth. In an article which recaps a variety of data points presented here previously, the FT summarizes that European banks continue to exist solely due to a record and unprecedented $1 trillion in emergency loans issued to Europe’s commercial banks. In turn, almost 40% of this liquidity is then recycled, and stored back with the ECB, as the very same banks have no trust whatsoever in any of their peers. In short: no matter what the Stress Tests indicate, the European financial system is now in a worse condition than ever in history, including the days just after Lehman.

From the FT:

The ECB is currently lending close to €900bn ($1,098bn, £728bn) to eurozone commercial banks, jumping to near-record levels since the creation of the central bank 11 years ago. This now matches cross-border lending between commercial banks in the 16-nation currency zone, according to JPMorgan.

Although lending between domestic banks represents the lion’s share of the estimated €6,300bn market, the ECB has become essential as a lifeline to the weaker of the 3,000 banks in the eurozone.

At least some people still have the guts to laugh in the face of JCT’s propaganda:

 
 

Paul Griffiths, global head of fixed income at Aberdeen Asset Managers, says: “Without financial support many banks would struggle. It would take a brave man to turn the ECB taps off.”

Summarizing just how critical the ECB’s role is in the proper functioning of European banks:

 
 

Since Lehman Brothers collapsed in September 2008, lending by the ECB to eurozone banks has risen sharply as it has offered unlimited loans and extended its liquidity operations. This has seen the sum it lends to the banks rise from about €500bn before the Lehman crisis to today’s near record levels.

As well as the offer of unlimited loans, the ECB has bought €55bn in eurozone government bonds and €60.2bn in eurozone covered bonds in an effort to revive the eurozone economy and boost sentiment.

However, fear still stalks the markets. Interbank dealers say credit blocks remain on Spanish and Greek banks because they are seen as too risky to lend to.

The fear of lending to other banks because they may fail to repay loans is also reflected in the large sums of cash being deposited at the ECB overnight.

In spite of offering only 0.25 per cent for deposits, commercial banks parked €305bn at the ECB on Monday night because they prefer the safety of placing their money with the central bank rather than lending to other banks at higher rates. Before the Lehman crisis, overnight deposits at the ECB were typically less than €10bn.

And a pretty chart showing just how contrary to fact are all European claims that all shall be well.

At this point it is worth reminding that the Fed is a paragon of transparency and openness when compared to the infinitely more nebulous ECB. One thing that can be assumed with certainty for both central banks, however, is that this $1 trillion+ in cash lent out is backstopped by some of the most toxic paper in existence. The collateral received in exchange for the cash, which in turn forms the asset side of the ECB’s balance sheet, is also the guarantor of the money in circulation in the eurozone, and is the implicit baker of the value of the Euro. Next time you wonder why more and more people are calling for EURCHF parity, keep in mind that almost a hundred billion in Greek bonds is just part of the worthless recourse backing that piece of paper in your transatlantic wallet.

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