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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
Decmber 22, 2011
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It is my view that heightened euro disintegration risk has unleashed destabilizing capital flight – within the euro region and without.  I’ll presume the flow out of Italian, Spanish, Greek, Portuguese and other “periphery” banks to Germany will equate to only more astonishing growth in “Target2” balances.  And I’m not sure why this wouldn’t turn into a serious issue for the ECB, the Bundesbank and for an already unsettled German political landscape.  The high standing in which the Bundesbank is held by the German people could be at risk.  For now, the ballooning of both the ECB balance sheet and claims owed to the Bundesbank will likely be a source of market worry, weighing further on the euro and creating greater momentum for capital flight out of the European financial system.

Interestingly, European periphery bonds rallied strongly into week’s end – while, uncharacteristically in such a circumstance, the euro struggled to catch a bid.  The ECB last week announced its Long-Term Refinancing Operation (LTRO).  This is an unlimited three-year liquidity facility that European banks will have the opportunity to tap next week.  Borrowing estimates vary from 100bn to as high as 350bn euros.  According to the Financial Times (“Doubts Over ECB Move to Boost Bond Sales” by Tracy Alloway), about half of the euro 614bn longer-term facility from back in 2009 was used to finance (mostly periphery) sovereign debt.  There has been talk that much of the demand for this week’s strong Spanish debt auctions had come from banks that will use this debt as collateral against this new ECB lending facility.  Especially in today’s liquidity challenged marketplace, LTRO-related buying may explain the rather dramatic decline in Spain and Italian yields, especially at the shorter end of yield curves (Spain 2-yr yields down 120 bps and Italian 2-yr yields down 76 bps this week).

But why no rally in the euro?  Well, if capital flight has become a serious issue then the markets will appreciate that ECB liquidity operations might now work to exacerbate outflows.  There reaches a point where central bank monetization morphs from a stabilizing force in the securities markets (bolstering prices and confidence) to being a potentially destabilizing provider of additional liquidity that might immediately seek safer havens in competing currencies.  It was, after all, capital flight and faltering currencies that over the years hamstrung central banks from Brasilia to Seoul.

For months now, market participants have waited patiently for European political resolve and crisis resolution.  Federal Reserve-like monetization from the ECB has been viewed as the trump card to be called upon in the event of political failure.  With failure at this point the base-case, attention has turned to a surprisingly unsteady ECB.  It is increasingly apparent that the ECB has much less flexibility and firepower than had been previously assumed, while the scope of the problem seems to expand by the week.  There is at this point alarmingly little to show for the massive ballooning of the ECB’s balance sheet (and “Target2” balances owed to the Bundesbank).  One is left pondering how the ECB/Bundesbank can be expected to backstop an almost unfathomable amount of vulnerable European sovereign debt and banking system obligations – not to mention potentially enormous capital outflows.

There was more focus this week on Europe’s “plumbing.”  How will markets and payment systems function in the event of major change – one or more countries exiting or complete disintegration - in the euro regime?  I expect this to be a major issue for the coming weeks and months.  If the euro as we know it today does not survive, there will be major market dislocations and bank failures.

If global market participants and business interests are forced to handicap the sustainability of the euro, then they will also have to contemplate the viability of European financial institutions.  Will the ECB backstop the banking system, or would it be left to individual national central banks?  Will there be massive monetization/“money printing” – and if so, will it be before or after euro-related financial dislocation – by the ECB or individual central banks?  To what extent would central banks back their national banking systems?  How would various scenarios impact myriad bank obligations, including senior and subordinated debt, along with Trillion upon Trillion of derivative obligations?

I’m rather confident that the more time analysts contemplate such issues the more apprehensive they will become.  Counterparty and derivative issues now take center stage.  And the more concerning these issues become, the more likely the rational outcome is capital flight.  The Russian banks were major players in ruble derivatives, providing insurance that proved worthless as the banks collapsed right along with the currency back in 1998.

There are hard decisions to be made.  Going forward, will one choose to hedge euro and European risk exposures in the derivatives markets?  Or does it reach a point where it becomes more rational to avoid counter-party issues and simply exit the region.  And for a hedge fund industry that for too long has operated as the marginal source of market liquidity around the globe, how do they game it?  Hedge fund operators will need to decide if they’re going to bet (or, more likely, stick with bets) on the “plumbing” functioning – and I guess their investors will decide if they agree with the premises of their fund managers.  It’s ironic that the big European “banks” used the carnage of the 2008 fiasco to boost their presence in the global (hedge fund and securities financing) prime brokerage and derivatives businesses.  It shouldn’t be too difficult to see the linkages from Europe and the euro to a very problematic global crisis.