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Jim Cook



Every once in a while I switch the TV channel from Fox to CNBC to see what the liberals are saying.  After listening awhile I get a deep sense of hopelessness and foreboding for our country.  The most important thing for the left is giving money to people.  They are happy to see the growth of food stamps, disability payments, housing subsidies, free healthcare and all the other welfare benefits.  They utterly fail to see the damage it is doing to the recipients.  Whole cities that once flourished have deteriorated into rotting eyesores populated with shambling hulks of chemically dependent drones.  These people are no longer employable.  They have become incompetent and helpless and the liberals can’t see that it’s their doing.

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The Best of Jim Cook Archive

Best of Doug Noland
January 17, 2012
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Euro disintegration is a key Issue 2012.  I no longer believe the current structure of euro monetary integration is viable over the long-, or even intermediate-, term.  Yet the financial and economic dislocation associated with a breakdown of the euro would be sufficiently catastrophic that the markets assume policymakers will not tolerate such an outcome.  This recalls the market perception that Washington would never allow a U.S. housing bust.  Such backdrops seem to ensure the most destabilizing circumstances.  They eventually unfold after policy measures are belatedly recognized as having lost the capacity to control developments and hold crisis at bay.

There is a common view that European policymakers, especially the ECB, have successfully bought time.  And over time policy measures will prove more effective, it is believed, and supportive of a more rational and normally functioning marketplace.  I am again reminded of the Fed’s aggressive monetary easing in ’07 and early-2008.  Responding to the unfolding mortgage crisis, the FOMC began slashing rates in the summer of 2007 and had pushed rates down to 2.0% by late-April 2008.  The S&P500 traded above 1,400 in May 2008, as market focus fatefully turned to profiting from policy moves and away from fearing the unfolding crisis.  Policy responses (to major crises) will tend to become more aggressive over time, corresponding conveniently with the markets’ limited capacity to worry about a particular crisis risk for too long.

I believe strongly that instead of “buying time” aggressive policymaking in the face of an unfolding Credit bust tends to only buy a more destabilizing crisis.  Policy measures are, once again, providing market participants ample time (and market liquidity) to hedge exposures to various European-related financial risks, certainly including a weaker euro.  And while these hedges tend to have a comforting effect on market sentiment in the near-term, the buildup of derivative exposures becomes an integral aspect of mounting systemic stress.  As we’ve witnessed in global markets repeatedly over the past couple decades, a major problem unfolds when a risk scenario that the marketplace had significantly hedged against actually comes to fruition.  There is no mechanism that allows the marketplace to effectively offload market risk.  The crisis becomes acute – and dislocation begins in earnest – when participants begin to lose confidence in the capacity of those who have written market insurance to fulfill their obligations.

I would be sticking my neck out if I downplayed the risk of a European financial meltdown.  Similarly, I would be playing it too safe to not highlight the risk in 2012 for a brutal global financial crisis.  The ECB’s massive Long-Term Refinancing Operation may have bought some time, but results so far are not encouraging.  Long-term yields in Spain and Italy remain elevated, and yields in France, Austria and elsewhere are moving higher.  Confidence remains fragile, whether it is with Italian finances or European bank solvency more generally.  A tightening of Credit conditions in Eastern Europe is taking an increasing toll.  Exposures to Hungary and other nations now add to European bank woes.  The Italian and French bank stocks, in particular, have performed poorly to commence the New Year.  How many bullets does the ECB have left to fire?  Capital flight out of Europe is an Issue 2012.

The euro trades miserably.  Assuming that there has been enormous protection written against a declining euro, a derivative-related market dislocation is not a low probability scenario.  Yet a view has gained traction that a weak euro is nothing to be feared.  Indeed, it is a consequence of the ECB finally responding with sufficient resolve.  And it is certainly true that the European debt crisis has been a gift to U.S. Treasuries and our debt markets generally.  This dramatic loosening of financial conditions in government and mortgage finance has given a boost to U.S. growth.  And there is, as well, newfound dollar strength that only emboldens the view that our markets and economy have become the envy of the world - and the indisputable “safe havens…”

I find it disconcerting that, at such a late stage in a historic Credit cycle, ongoing U.S. and Chinese Credit booms remain central to the bullish market thesis.   Back in ’07 and ’08, we watched how a crisis of confidence at the periphery of mortgage Credit eventually brought down the core.  In 2010 and 2011, a crisis in Greece rather methodically enveloped Europe’s periphery before setting its sights on the core.  This irrepressible periphery-to-core contagion dynamic will remain A Key Issue 2012.

From a European sovereign debt standpoint, the vulnerable core includes, of course, Italy and Spain, but increasingly Austria, Belgium and France, as well.  More from a financial system standpoint, the core includes the nebulous (“AAA”) repurchase agreement (repo) marketplace.  As confidence in the European banking system wanes, trust in a wider array of previously perceived riskless securities and financial arrangements suffers.  And if confidence falters in various European instruments and obligations comprising contemporary “structured finance,” one could envisage a scenario where similar fears jump the Atlantic and infect the core market for such products on Wall Street.

It is difficult for me to believe we won’t be hearing a lot more about counterparty and derivative issues over the coming weeks and months.  And while there’s a case to be made that U.S. Credit and economic activity may have even benefited from Europe’s woes, our financial markets and economy are anything but immune to Credit bust dynamics.  A more general crisis of confidence in global financial claims could perhaps even unleash panic buying of hard assets and claims to more reliable stores of value.