Europe on the Brink – China says “get your house in order”

September 14, 2011

Global Macro

A plethora of drivers today in Asia which highlight the risks around being long risk assets in this current market.

That old bellwether of global sentiment, risk and growth the AUD/USD exchange rate got pummelled this morning after looking like it was trying to base over the last day or so. Ostensibly the actual catalyst for the move was the ABS revisions to the Australian CPI data. Paul Bloxham from HSBC said in a note to clients,

 The statistics bureau today announced downward revisions to the RBA’s preferred underlying inflation measures, as part of a review. These revisions are due to changes to the seasonal adjustment technique. The trimmed mean, which was running at 2.72% y-o-y to Q211, will be revised to 2.50%, and the weighted median, which was 2.67%, is now2.60%. Q2 inflation also looks distinctly weaker on the new estimates. The revisions knock 0.15pp off the history of they-o-y numbers which, on their own, could allow the RBA to push their latest y-o-y forecasts of 3.25% for 2011 down to the top of their target band, at 3%.
The AUD’s fall was pretty close after this announcement and was synchronous with the drop in the 3 year swap rate suggesting that market players correctly feel that the RBA now has more wriggle room to cut rates and far less pressure than was apparent to keep its aggressive tightening bias.
 
But to the extent that the ASX 200 turned down (when this CPI announcement was actually good news for shares) to close 1.64% lower and the Nikkei was off 1.14% we see that perhaps there was more at play than just the Australian CPI.
 
But the big news came out of China with Bloomberg reporting that Chinese Premier Wen Jiabao said that China is ready to help the developed western economies but that they needed to clean up their act. Bloomberg reported,
 “Countries must first put their own houses in order,” Wen said today at the World Economic Forum in the Chinese city of Dalian. “Developed countries must take responsible fiscal and monetary policies. What is most important now is to prevent the further spread of the sovereign debt crisis in Europe.”

Stocks dropped in Asia as Wen’s comments damped optimism that China can help stabilize the euro-region, after Italy this month followed Spain, Portugal and Greece in seeking Chinese investment. Wen said that the sovereign debt crisis in Europe is spreading, and a former adviser to China’s central bank said the nation should avoid buying bonds from European countries where leaders and central bankers are in disarray.

 Wen reiterated his message in June that China can offer “a helping hand” to Europe through investing there. At the same time, his government would ensure the nation’s economic growth remained stable, he said today. Wen called on the European Union and the U.S. to open their markets in return.

“What he is basically saying is China wants to help, they want to invest, but we can’t help you take the proper measures to control the debt crisis, you’ve got to do that on your own,” said William Rhodes, a senior adviser to Citigroup Inc. who was at Wen’s speech.

We are seriously worried about Europe as readers know and to compound this news from China Moodys have acted on concerns over French Banks by cutting the ratings of Societie Generale and Credit Agricole 1 notch each but has so far keep BNP on its current rating.
 
It’s certainly true as I write that European shares and US equity futures are back from their worst losses for the day, so far, but it just feels like this mess is getting worse and worse and even though markets have had plenty of time to get ready for a Greek default I wonder if they are ready given there is still a level of complacency about the extent of the impact of a Greek default.
 
For example yesterday in Australia Fairfax Business writer Michael Pascoe wrote a piece that was far too sanguine on the impact of Greece saying,  

Hands up anyone who thinks a Greek debt default is inevitable. OK, absolutely everyone can all put their hands down. That’s what Europe’s banks think too – and have for quite a while now.

While the threat of European sovereign debt sparking another financial crisis roils markets, not all the supposed surprises are actually surprising.

For example, there’s not much Greek debt in French banks that hasn’t already been written to market, which, on the face of it, means the actual balance sheet impact of a formal Greek default would not be disastrous. Greece defaulting would not per se crash banks outside Greece.

Already we have seen what Moodys have done today and I wanted to highlight some work I did for a piece written by Houses and Holes over at MacroBusiness for an article yesterday afternoon which highlights the fact that markets are really concerned about Europe and it is heading toward the sort of fractious market that we saw in 2008. Here is some of yesterday’s piece with updated charts for today.
 
Take the current market pricing for example, while expectations about the ECB cash rate – OIS – have been revised lower,  (white line in below chart) the bank funding rate that is drawn from the cash rate – Euribor – has not fallen at all much (orange line):
 

The OIS shows you the cash rate expectations of the market. In a “normal environment” bank funding costs (the Euribor rate) would move with this expectation of cash rates. But when the spread between them blows out, the market is signaling an increase in bank credit risk. In short, the falling cash rate is currently covering the rise in interbank rates but the Euribor-OIS spread, the yellow line on the chart, is still telling us something about European bank risk.

But that still doesn’t mean much unless you look both at history and other markets. As the chart below shows, going back to June 2008, Euribor-OIS spread has rocketed higher while USD Libor – OIS and JPY Libor – OIS has not. Check out the yellow line on the chart below, that’s Europe – it may not be 2008 but it’s well on its way:

It is some cause for reassurance that to date the USD OIS spread has not been affected. But my feeling is that what will happen in the event of a Greek default is that US banks will stop lending to European banks. Hank Paulson, Ben Bernanke and Tim Geithner didn’t want Lehman to head into bankruptcy but they calculated that markets could cope with a Lehman collapse after months of turmoil. Clearly they underestimated the fear and panic that ensued when no one knew which banks were holding what. It is my fear that we will repeat this in the event of a default.

As I write Bloomberg is saying that the ECB said it will lend dollars US Dollars to Euro area banks. So funding is getting difficult in Europe for financial institutions.
 
It didn’t have to be this way but that’s the hand that political, policy and regulatory intransigence has dealt us. We remain of the view that cash is king.
 

greg@lighthousesecurities.com.au

www.twitter.com/gregorymckenna

This blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.

If you do need economic, investment or financial advice we are happy to help.

Please Email the team at Lighthouse at info@lighthousesecurities.com.au or Greg directly on greg@lighthousesecurities.com.au

 

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