Without much financial press fanfare, Cyprus needs a bailout. The country is going bankrupt, elections in Feb (17th), banks will run out of money in March. Among the bailout issues are:
1)Will state assets be sold as part of the bailout plan
2)Will private creditors take a hit, write downs, on the government bonds they own?
3)Where will the 10 billion Euro capital come from that the banks need to recapitalize?
What does it all mean?
The fundamental conclusion is, the modern-day welfare state's financial underpinnings have been exposed as unsustainable. Not only are current deficits not fundable without QE, but unfunded liabilities render nearly all modern-day welfare governments bankrupt if GAAP accounting were used. Also, all entities owning the debts of these governments, mostly banks, would be bankrupt as well because all the paper they own should really be valued substancially less than face value-perhaps as low at 15-20%.
So what we have in the financial world today is a "confidence" game. "Confidence" waxes and wanes as a function of the effectiveness of QE-which is not the actual printing of money (QE increases bank's ability to lend by flooding then with reserves)-money is created when banks actually make loans. Needless to say, banks have, on deposit with the FED, trillions of $s of excess reserves.
So, what am I getting at? Welfare states are being financed by QE, which over time, will not succeed because, the process, violates economic laws. What laws am I talking about? More on that later.
Right now, given the ECB's comments that it will do QE if a country in trouble asks for aid, the FED's increased 2013 QE commitment and the BOJ's increased QE targets, "confidence" is high that the "back-door" printing press will be effective. But the larger problem remains, modern-day welfare states are not fundable without QE either the existence of a current program or the future promise on a new one to be implemented.
Expect news, over the next couple weeks, of a bank run out of banks in Cyprus. May mean nothing, but then again, depending on what exposure large European banks have to Cyprus-it could weaken the Euro-sending the $ higher and stocks, commodities lower. At any rate, info out of Europe continues to be dismal-at some point in time the ForX markets will have to drive the Euro down into the mid 1.20s.
To get bake on track w/r to Cyprus and the implications for the Euro-zone. Briefly touched upon was the housing crisis in Denmark, not covered much in the news but several financial institutions have been downgraded by Moody's because of their real estate exposure in that country. Also, with France's military strikes in Mali, over the weekend, Islamic forces have promised retaliation in France itself. Given the Euro's strength in recent weeks, when no fundamentals have improved (stock and bond markets are up), but industrial production continues to fall while umemployment increases, the risk of a negative headline has increased. Accompanied by an over-reaching Euro, the chances for a Euro rout and a $ resurgence is high, in my mind, in the coming weeks.
Implications, if you are a buyer of stocks in the near future, I am suggesting you take only partial positions, because lower prices later will be available.
Glad to read here and NVTL SEC filings that a large investor has taken a 9.1% position. Now if he would only ask mgt to put the company up for sale, we could all get $2.25+ and be gone. Additionally, QLGC pre-announced a strong Q and is still cheap under $11.00
Still, I am bearish on the Euro, which by default if I am correct is bullish for the $. Even though there has been recent enthusiasm for Euro equities and south Euro debt, continuing and new problems will reverse that recent optimism.
France is going to have a tough time w/r to their war efforts in Africa-they can't afford it anyhow
Spain's banks own 2/3 of all government debt, the Spanish Social Security Fund has 90%+ of its portfolio in Spanish bonds, so basically all big domestic buyers are way over weight Spanish bonds. That means foreign buyers will have to absorb this year's huge supply. They may for awhile, but bad news out of either Spain or the Eurozone, will #$%$ those buyers into sellers. Germany will report a terrible negative growth 4th Q and with the Euro so strong, a rebound in the 1stH of 2013 seems doubtful.
Bottom line, a $ rally that could last weeks, would take stocks and commodities down for weeks or 2-4 months. Looking to be a buyer after that: S&P500 around 1350, oil $70, gold $1400-$1500.
Got off track with the prior post w/r to the implications of Cyprus bailout. Along with the process of the Cyprus bailout, will be the Italian election and housing bubble issues in Denmark, I can't see how the Euro can continue to rally. So maybe we get to $1.34-$1.35, from the 1/11 intra-day high of $1.3364, but that is it. A $ rally would then be bearish for oil, gold, and stocks9 for a few months) if it coincides with the FED pulling back from its recent M2 "bulge" addressed in other posts.
OK, so we have the big issue again-QE and its effectiveness on the real economy and/or is it just "energy" for the game of musical chairs-all part of the greater "confidence" game being played by central banks.
It is important to note that QE, in and of itself, does not constitute printing money-despite commentary by the alarmists. I'll explain as I understand. When the FED buys government bonds, in the open market from banks, it credits banks accounts at the FED thereby increasing the bank's reserves. With reserves increased, banks ability to lend has increased-currently there are about $1.5 trillion of excess reserves banks have at the FED-by far and away a historic high. Now if the FED were to buy government bonds from the government directly, that would be printing money. As far as I know that is not happening in the US.
Up until recently, banks were not expanding their lending. However, as I have been posting, loan growth have been consistently expanding the last 10 weeks. As we all know, money has returned to the housing and auto markets along with commercial and industrial loans. Now if the growth in loans and M2 increases the supply of goods and services at nearly identical %s, then QE will not be inflationary as increases in production (goods and services) matches M2 growth. Excess M2 growth above growth in production would, over time, tend to predict the inflation rate. Roughly:
M2 growth=nominal GDP=real GDP growth+ inflation
So, what I am getting at is QE will not necessarily lead to rapidly rising or hyper inflation-as long as the loan growth is for productive uses.
Herein lies a couple problems:
1)In a prior post I offered up stats that suggested it took more and more debt to increase GDP
The implication is expanding debt, at the margin, will bid up prices vs increasing production
2) Aggregate productivity, while still increasing, has been increasing more slowly in recent years. Additionally, policies out of Washington are hindering productivity growth
So, given recent loan and M2 growth, bank's huge reserve positions at the FED and "1,2" above, the odds of inflation increasing are very high. Then we get back to the FED. When will they become alarmed and start to wind down or stop QE? With that, with prices bid up and the expected outlook that the private sector will have to finance deficits on their own, what will become, financially, of the modern-day welfare state that got hooked on QE for its financing (government sells bonds to banks, banks sell same bonds to FED, FED creates reserves for banks, banks make loans off reserves that have near 0% cost basis? To a financing model of government sells bonds to real investors vs banks under QE knew they could immediately resell the bonds to the FED, where real investors (some may be bond vigilantes) want a real positive historical return (2.5% as an example for the 10 yr bond) above and beyond the expected inflation rate-now higher because of the prior QE policies.
In addition, accumulated debt, both public and private, and unfunded liabilities will be higher, when that time comes vs today. What interest rate will those government bond buyers demand? You can bet it will be high single digits and if there is a $ crisis, double digits. Not in the mind of investors today, late late 70's/early 80's rates could be possible. No need to paint the picture of what will happen to the real economy that got hooked on artificially low interest rates to finance a modern-day welfare state that was not sustainable.
To tie it all together, Greece, Portugal, Ireland, Spain, and Cyprus all needed bailouts because their governments got to large to be supported by their respective private sectors and they did not have their own currencies with which to buy more time. Japan, UK, and the US have the same problems, their governments are too large for their private sectors to support, but with central bank QE, they can buy time, confidence all in the hopes their private sectors grow large enough to support their still increasing governments.
That is the key, whether it (QE) will work or not, will the private sectors grow enough to support ever increasing size of government. On the other side of the coin, to increase the odds of success-governments should be decreasing in size. Well we all know which way the US is going-increasing its footprint of the modern-day welfare state. Bottom line, QE is geared to "juice" the private sector to support the increasing welfare state. It is not going to work.
When QE comes off, because of increasing inflation, the bond market will require much higher levels of interest rates to compensate for: real rates of return, inflation, increasing default risk. Whatever those rates are, will crush the economy accustomed to borrowing at negative real rates at very low absolute levels. Tax revenues will fall dramatically, the welfare state will be dismantled by default-it simply will not be able to keep prior promises and/or pay many bills.
The correct path, since QE is already in place is too shrink government at every turn with incentives set up for the private sector to take over. For example:social security should be eliminated in 30 years. All it is is a tax on labor, reducing current employment, and people should save for themselves. Medicare and medicaid should also be eliminated, with insurance issues, as per the 10th amendment to the constitution, be regulated by the states. If a particular state wants to subsidize health coverage, that is their choice-they will either attract people or drive them out depending on how well it is managed for the tradeoff of higher taxes. Competition from other states will act as a force to keep cost in line. Also, we don't need a department of education at the national level and so on and so on.