A three-way split

Whatever residual worries there were going into the deadline for the Greek deal, they did not seem to have impacted sentiment elsewhere, as it neared.

For example, the twin LTROs (plus the Monti factor) had pushed BTP spreads and outrights lower across the curve; Euro bank stocks stood close to 7-month highs  – both outright and relative to broader market; the Euro-USD basis swap was the least negative in six months (an easing of the ability to fund in dollars also being reflected in the 35%, $38 bln drop in take up of the Fed’s emergency FX programme); swap vols were at 7-month lows and were falling v-a-v US equivalents; stock vol—though brought off the bottom in the 3-day, 3.7% slide—  were still within sniffing distance of an 8-month low; ditto interest rate swap spreads.

So—surprise, surprise—a sizeable super-majority was achieved and the world could draw at least a temporary sigh of relief at clearing this, the latest  of what will undoubtedly be many more hurdles to come until the Much-enduring One struggles home, over the wine-dark sea to Ithaca.

With this distraction behind us, we are left to focus on the growth prospects for a Continent where the process of readjustment has been painfully slow, hampered, as it has been firstly by a supra-Japanese style reluctance to insist that capitalistic selection cannot be allowed to weed out the least fit from among its bloated population of second– and third– rate banks and, secondly, by the short-circuiting of the essential adjustment to the chronic, competitiveness-sapping, single-currency generation of ‘deficits without tears’ via the egregious TARGET2 system in all its €600 billion inglory.

Though our recent graph of major central bank balance sheet expansion has attracted some wider attention (as well as one or two unreferenced imitations), we have been at pains to stress that much of the inordinate jump in the ECB’s contribution to that total was not as directly inflationary as were those of, say,  the Fed, or the PBOC.

This, we have argued, was because much of the central bank’s action was to insert its implicit guarantee between Eurozone banks which had collectively shrunk their lending to their peers in other countries in the Zone by more than a quarter—a hefty €790 billion—as mutual distrust had mounted ever higher. Simultaneous with this withdrawal of facilities, the ECB expanded its balance sheet (ex-revaluation effects on its reserves) by some €975 billion. Thus, some four-fifths of the gain was merely ’credit-wrapping’, if doing so with a far more high-powered money which carries a far greater potential to fuel future private sector credit expansion than the funds which it replaced.

Since then, of course, a further €290 billion has been thrown into the pot in the attempt to trigger exactly such an expansion by undertaking what Helmut Schlesinger rightly disparages as an act of ‘War Finance’ whose ultimately inflationary consequences are likely to require either currency reform or a command economy to control. Time will only tell to what extent this policy has succeeded but, even if it does, if we only recall the typical lag of six to nine months between changes in the smoothed rate of real money growth and its percolation through the complex interweaving of revenues and outlays—and hence, income, consumption, and investment—the current awful trajectory of Europe’s macro numbers may well continue at least until the summer.

Across the Pond, conditions could not be more contrasting. Banks have—at least ostensibly—been restored to a modicum of health, with both capital:asset and loan:deposit ratios relatively subdued, even if the relation between doubtful loans and loss provisions has been pared a little too quickly for prudence in such an artificially low rate environment.

Summertime and the money is easy. What a difference has greeted the efforts of the Fed in comparison to the paltry returns seen on those of its European counterpart. Its Chairman has been able to spend as much as it takes propping up his TBTF babies; he has been able to kickstart the money creation process by financing a vast and still yawning government budget deficit; meanwhile, smaller banks have been helpfully weeded out in a rapid resolution process mediated by the FDIC.

Blackhawk Ben has not had to wrestle with any overall credit contraction (if only because an ever-eager Uncle Sam has been typically glad to seize the chance to sequester more real resources from its citizens) and so he has only had to preside over the gentlest of aggregate ’deleveragings’, one which has only been registered relative to the expanded count of national income and not in any absolute sense.

Despite a certain embarrassment along the way with rising prices last year, other people’s tightening efforts (notably in the emerging market engines of recovery) have spared Ben much difficult decision-making. Fortuitously, too, a goodly portion of the inflationary injection has stuck anomalously to the fingers of a corporate sector saddled with an unusual degree of certainty about its members’ individual prospects as well as about those relating to the fiscal and regulatory environment at large.

Thus, in devoting 85% of retained earnings—or 20% of ex-dividend, after-tax cash flow—to accumulating a $630 billion mountain of money (cash plus demand deposits) over the past 2 1/2 years, these most unlikely of ’hoarders’ have helped retard the incendiary effects of the Fed’s actions—for now.

This—together with the collapse in the ratio between the monetary base and the money supply itself—has fooled the more mechanistic of the quantity theorists into believing the machinery of debasement has been broken. Meanwhile, the cranks who comprise the MMT mob are crowing that the gold bugs and associated survivalists who inhabit the wilder fringes of the hard money world (whom they insist on conflating with us REAL Austrians) have again been horribly awry in uttering their cries of ’Wolf! Wolf!’

In truth, none of this is so hard to explain.

As for money creation itself, the LEH-AIG-EUR disruption has radically altered the normal generation of money, but has not caused its suspension. In fact, given the speed of its operation since the Crisis, we could even say its efficiency has been greatly enhanced, boosting the stock:GDP ratio to a four decade high after delivering the fastest increment to that datum on record!

Before that watershed, the Fed typically gave rise to around one quarter of the nation’s money (OUTSIDE the commercial banks, in the form of currency and reserve balances) while the remaining three-quarters used to be originated INSIDE the banks (by their grant of loans or their purchase of securities against the recording of a credit balance on the relevant demand deposit account in their books).

Since then, however, the position has been largely inverted, so that the banks themselves are now responsible for something barely in excess of two-fifths of the total, with the Fed supplying the other three-fifths through its various ’emergency’ programmes.

No-one should be under the illusion that just because the monetary base (the Fed’s particular contribution) has swollen dramatically in relation to the sum of the banks’ discretionary additions to it, this makes the whole any less spendable or any less assured in its provision—quite the contrary, given Mr Bernanke’s inflationary bent and the lack of restraint which attaches to the monstrous institution whose awful power he arbitrarily wields.

The upshot of all this is that somewhat more than half the curtailment of hours worked in the crash have since been recovered and the sum is now growing at a pace above 4% annualized. Manufacturing is at last sharing in the move, but has almost two thirds to recover to what will still be a level otherwise marking a post-War low.

Business revenues, too, are climbing—making new nominal highs—and, in volume terms, possibly even quickening their ascent. The US is the least sick Western nation, as we write.

That, of course leaves an Asia just beginning to emerge from behind the bamboo curtain of the lunar new year.

The first batch of Chinese numbers have begun to excite the market for just the perverse reasons we have been discussing. Fair is foul and foul is fair because a slackening economy is seen to hasten the great day when the clarion will sound and the messenger of heaven will ride out and start the next round of ill-advised credit expansion.

What we in fact received was evidence of a minor uptick in the money and credit numbers. Nonetheless, we must recall that the first of these are still at their weakest level in the 20 years or so for which we have numbers, while the latter suggests that banks are still bumping up against their mandatory loan:deposit ceilings, thus limiting their ability to respond to any putative RR cut as aggressively as they might.

As expected and frequently emphasised here, this degree of restraint is not only now decelerating the CPI, but actually curtailing it, and real side activity also remains predictably subdued, as seen in both export data and the HSBC/CLSA PMI series.

We are undoubtedly getting to the point where the PBOC could be more active if it so chose, but the harder questions remain, as previously discussed: how much of this is already in the price and how quickly will real-world demand respond to any partial reversal of last year’s tightening?

Such information as we have about China’s interlinked Asian industrial neighbours has hardly been reassuring of late – sales, trade, and output have all been struggling and, outside of Japan, monetary conditions have been none too accommodating either. If the PBOC re-enters the lists, much of this will, of course, be swept under the carpet in the dash to add to Risk On positioning. It will be none the safer an action for being so far in advance of an uncertain reality, for all the enthusiasm likely to be mustered when it comes.

To the extent that the re-establishment of long positions, undertaken since the autumn, has been a momentum trade, rather than being based on anything more solid, dangers clearly intensify. Our argument, repeated several times since the end of last year was that players have begun to rely on the rapidly repeated stop-go cycle of highly bullish episodes of central bank Vollgas interspersed with periods in idle of the sort which, though comparatively mild in the degree of restraint they offer, cannot be abided by a pricing structure arguably bereft of a firm, fundamental underpinning.

That same market has weathered a good deal of unlooked-for leisureliness on the part of the PBOC (a posture which our reading of the Chinese political pressure points had, conversely, led us to assume). It hardly blinked when the Fed was forced—by the sustained run of monetarily-boosted economic numbers—from unleashing QEIII (again, something we had thought was highly likely as soon as the M-numbers started to take on a life of their own last autumn). Finally, it has become more or less inured to EuroAngst,  if not, conversely, being immediately given over to raptures concerning the second LTRO or the conclusion of the Greek debt swap.

Advance is thus largely predicated upon hope, not reality. But then—as that admirable observer of financial folly, Frederick Lewis Allen, put it long ago—in speculative markets, hope can be readily parlayed into cash. Several key entities are poised at or near levels whose breach could open the way for the Herd to pour onward and upward, especially in US equities. For us, the outlook in the first half of 2012 has always been a delicate balancing act between the hope of renewed stimulus and the reality of dysfunctional price signals, cluttered balance sheets, and that curious political cocktail which consists of an over-eagerness to act and a fear of acting decisively.

If pushed, we still think that enough Greater Fools yet exist to take us up awhile, but our conviction is low and our stops are tight.