MacroScope

from Mike Dolan:

Sparring with central banks

Just one look at the whoosh higher in global markets in January and you'd be forgiven smug faith in the hoary old market adage of "Don't fight the Fed" -- or to update the phrase less pithily for the modern, globalised marketplace: "Don't fight the world's central banks". (or "Don't Battle the Banks", maybe?)

In tandem with this month's Federal Reserve forecast of near-zero U.S. official interest rates for the next two years, the European Central Bank provided its banking sector nearly half a trillion euros of cheap 3-year loans in late December (and may do almost as much again on Feb 29). Add to that ongoing bouts of money printing by the Bank of England, Swiss National Bank, Bank of Japan and more than 40 expected acts of monetary easing by central banks around the world in the first half of this year and that's a lot of additional central bank support behind the market rebound.  So is betting against this firepower a mug's game? Well, some investors caution against the chance that the Banks are firing duds.

According to giant bond fund manager Pimco, the post-credit crisis process of household, corporate and sovereign deleveraging is so intense and loaded with risk that central banks may just be keeping up with events and even then are doing so at very different speeds. What's more the solution to the problem is not a monetary one anyway and all they can do is ease the pain.

Low interest rates and liquidity schemes can't solve what ails the developed world. Societies must accept that in order to alter their current perilous course they must undergo great change, moving away from entitlements to which they have become accustomed. The alternative is weak economic growth, a loss of competitiveness and negative external balances -- a loss of face and place in the global hierarchy.

As if to reinforce the underlying point that the developed world faces a protracted reform period that tests political, economic and social priorities, credit rating firm Standard & Poors' -- not the most popular company in corridors of power over the past year -- warned on Tuesday  that it may downgrade the debt of "a number of highly-rated" Group of 20 countries from 2015 if their governments fail to enact reforms to curb rising healthcare spending and other costs related to ageing populations.

European rescue: Who benefits?

The words “European bailout” normally conjure up images of inefficient public sectors, bloated pensions, corrupt governments. But market analyst John Hussman, in a recent research note cited here by Barry Ritholtz, says the reality is a bit more complicated:

The attempt to rescue distressed European debt by imposing heavy austerity on European people is largely driven by the desire to rescue bank bondholders from losses. Had banks not taken on spectacular amounts of leverage (encouraged by a misguided regulatory environment that required zero capital to be held against sovereign debt), European budget imbalances would have bit far sooner, and would have provoked corrective action years ago.

In other words, even if state actors mishandled government finances, Wall Street was, at the very least, an all-too-willing enabler.

EU might treat itself to treaty change

By Robert-Jan Bartunek and Robin Emmott

French statesman Charles De Gaulle once famously said “Treaties are like roses and young girls — they last while they last.” Germany seems to have decided that the European Union’s Lisbon Treaty, which only entered into force after a fair amount of upheaval in December 2009, has lost its perfumes and must be reworked to ensure the euro zone’s debt crisis can never be repeated.

European Council President Herman Van Rompuy’s proposal to modify the treaty via a little-known section called protocol 12 has so far been unable to convince German government officials, who warned against a “bad compromise” of small steps or “little tricks.”

Van Rompuy’s sense is that changes to the protocol, which would strengthen legislation to prevent countries running up big budget deficits, could be agreed quickly and send a message to investors that the euro zone is embarking along a path to bring back confidence and resolve its crisis.

The Fed’s stealth monetary ease

Banks took more than $50 billion from the European Central Bank on Wednesday in the first offering since it, the Federal Reserve and other major central banks slashed the cost of borrowing dollars in response to a worsening euro zone crisis. The high volume of emergency borrowing was seen as a sign that some of the region’s banks are having  problems obtaining dollar funding.

This means that, as our friend Mike Derby aptly predicted, the Fed’s balance sheet, currently around $2.8 trillion, will show a big increase when its weekly custody holdings figures are released on Thursday.

If one believes, as the Fed does, that the extent of unconventional monetary stimulus depends on the stock of assets the central bank holds rather than the “flow” of its interventions in Treasury and mortgage bond markets, then this amounts to a defacto monetary easing – about 1/12 of the Fed’s $600 billion QE2 bond-buying program.

Unlimited fun, not funds, on ECB’s iPhone app

But we never pre-commit

Who says central banking is boring? The European Central Bank, now grappling with safeguarding the survival of the euro zone, has made it to iTunes, with its monetary policy app “€conomia”. It challenges iPhone and iPad users with — you guessed it — keeping inflation at just under 2 percent. The new app is the on-the-go version of “The Monetary Policy Game” that has been available on its website for some time.

What is most striking is not the funky music soundtrack you would expect to hear playing quietly in the background while the Governing Council meets to set policy in Frankfurt. What really sticks out is the lack of monetary policy tools at the user’s disposal.

You can cut, raise or hold the benchmark interest rate, read up on the press coverage, and watch the economy thrive, stagnate, or flounder.

Contemplating Italian debt restructuring

This week’s evaporation of confidence in the euro zone’s biggest government debt market — Italy’s 1.6 trillion euros of bonds and bills and the world’s third biggest — has opened a Pandora’s Box that may now force  investors to consider the possibility of a mega sovereign debt default or writedown and, or maybe as a result of,  a euro zone collapse.

Given the dynamics and politics of the euro zone, this is a chicken-or-egg situation where it’s not clear which would necessarily come first. Greece has already shown it’s possible for a “voluntary” creditor writedown of  the country’s debts to the tune of 50 percent without — immediately at least — a euro exit. On the other hand, leaving the euro and absorbing a maxi devaluation of a newly-minted domestic currency would instantly render most country’s euro-denominated debts unpayable in full.

But if a mega government default is now a realistic risk, the numbers on the “ifs” and “buts” are being crunched.

from Amplifications:

The ECB’s battle against central banking

By J. Bradford DeLong
The opinions expressed are his own.

When the European Central Bank announced its program of government-bond purchases, it let financial markets know that it thoroughly disliked the idea, was not fully committed to it, and would reverse the policy as soon as it could. Indeed, the ECB proclaimed its belief that the stabilization of government-bond prices brought about by such purchases would be only temporary.

It is difficult to think of a more self-defeating way to implement a bond-purchase program. By making it clear from the outset that it did not trust its own policy, the ECB practically guaranteed its failure. If it so evidently lacked confidence in the very bonds that it was buying, why should investors feel any differently?

The ECB continues to believe that financial stability is not part of its core business. As its outgoing president, Jean-Claude Trichet, put it, the ECB has “only one needle on [its] compass, and that is inflation.” The ECB’s refusal to be a lender of last resort forced the creation of a surrogate institution, the European Financial Stability Mechanism. But everyone in the financial markets knows that the EFSF has insufficient firepower to undertake that task – and that it has an unworkable governance structure to boot.

from Global Investing:

Phew! Emerging from euro fog

Holding your breath for instant and comprehensive European Union policies solutions has never been terribly wise.  And, as the past three months of summit-ology around the euro sovereign debt crisis attests, you'd be just a little blue in the face waiting for the 'big bazooka'. And, no doubt, there will still be elements of this latest plan knocking around a year or more from now. Yet, the history of euro decision making also shows that Europe tends to deliver some sort of solution eventually and it typically has the firepower if not the automatic will to prevent systemic collapse.
And here's where most global investors stand following the "framework" euro stabilisation agreement reached late on Wednesday. It had the basic ingredients, even if the precise recipe still needs to be nailed down. The headline, box-ticking numbers -- a 50% Greek debt writedown, agreement to leverage the euro rescue fund to more than a trillion euros and provisions for bank recapitalisation of more than 100 billion euros -- were broadly what was called for, if not the "shock and awe" some demanded.  Financial markets, who had fretted about the "tail risk" of a dysfunctional euro zone meltdown by yearend, have breathed a sigh of relief and equity and risk markets rose on Thursday. European bank stocks gained almost 6%, world equity indices and euro climbed to their highest in almost two months in an audible "Phew!".

Credit Suisse economists gave a qualified but positive spin to the deal in a note to clients this morning:

It would be clearly premature to declare the euro crisis as fully resolved. Nevertheless, it is our impression that EU leaders have made significant progress on all fronts. This suggests that the rebound in risk assets that has been underway in recent days may well continue for some time.

Supervising the supervisors

A new Brookings Institution report from the self-appointed Committee on International Economic Policy and Reform suggests that, given a spotty recent record, supervisors and policymakers at the world’s top central banks need to be watched themselves. The group of 16 high-profile economists and financial experts, which includes former Brazilian central bank chief Arminio Fraga, Berkeley professor Barry Eichengreen, Harvard’s Kenneth Rogoff and Mohamed El-Erian from Pimco, proposes a new international watchdog that might ensure actions taken by individual countries are coordinated and smoothed out:

We call for the creation of an International Monetary Policy Committee composed of representatives of major central banks that will report regularly to world leaders on the aggregate consequences of individual central bank policies.

The proposal comes as the Federal Reserve, faced with a weakening U.S. economy, ponders another round of unconventional monetary stimulus. Many analysts believe the Fed will take some type of step to support low long-term rates at its September 20-21 meeting. When the Fed implemented its second round of bond-buying, it came under harsh criticism from emerging economies for pushing up their exchange rates with ultra-low rates in the United States.

Italy under fire as debt crisis heats up

It’s been a rough week for the euro zone and Italy is feeling the pain.

Despite regular purchases of Italian bonds by the European Central Bank since August — a policy aimed at keeping funding costs affordable — yields on benchmark 10-year Italian government bonds rose as high as 5.6 percent this week. Before the ECB started intervening in the secondary market, yields surged above 6 percent. Beyond 7 percent, funding costs are perceived to be unsustainable.

This raises questions over the effectiveness of ECB policy – doubts heightened  by the shock news that the central bank’s chief economist Juergen Stark would leave the institution early because of disagreements over the bank’s bond-buying policy.

The news highlights the rift inside the central bank over the handling of the worsening debt crisis. It drew a dramatic close  to a week of uncertainty: a debt swap meant to help Greece avoid default hung in balance;  a row over collateral for Greek bailout loans remained unresolved; and national parliaments had yet to ratify increased powers for the euro zone’s rescue fund.