Tuesday, December 20, 2011


There is an almost universal skeptical view on the ability of leaders to deal with the European debt crisis, on the prospects for U.S. domestic economic growth and with regard to any upside in the U.S. stock market.

December 19th marks one year since Meredith Whitney appeared on the CBS newsmagazine 60 Minutes and sent the municipal bond market into a tailspin from which it took months to recover. To recap that event: Ms. Whitney, a noted bank analyst, appeared on 60 Minutes and forecast "hundreds of billions" in municipal defaults during 2011. The result was a two- to three-month siege on the municipal bond market, which was already in the throes of a supply bulge because the Build America Bonds (BABs) program had expired.

So as we head into the last two weeks of 2011, we can look at how tax-exempt yields stack up against US Treasuries on a relative basis now and in the middle of the Meredith meltdown last January. There is no question that munis are cheaper, on a relative basis, across the whole yield curve, particularly on the front end. But it is extremely important to note that municipal yields have moved in the same direction (down) as Treasuries - just not as much. The Congressional squabble over the debt ceiling, the downgrade of the United States by Standard & Poor's, and the Federal Reserve announcement of its "Operation Twist " in September all led to drops in Treasury yields, and munis – begrudgingly, in some cases – followed along. The muni market fought those events off, along with the Harrisburg and Jefferson County situations, and made the long trip back from the despair of a year ago.

The flight-to-safety trade is still in place, as manifested in a yield on the 10-year U.S. note of 1.83% and continued relative strength in consumer staples.

The only economic news this morning was the National Association of Home Builers Index, which rose by two points, to 21.

Though still weak relative to history, most components of the index were on the mend -- especially traffic, which rose by the most in nearly 3.5 years.

Foreclosures, high unemployment and credit availability continue to plague the residential real estate sector.

After Europe's leaders and central bankers misdiagnosed the magnitude of the continent's debt crisis and after responding in an ineffectual and almost effete manner, the great unraveling of the eurozone is on our doorstep.

The threat of decomposition of the EU has trumped evidence of an improving U.S. economy and has resulted in (historically) low stock market valuations, restricting any upward progress in share prices and (more importantly) raising the specter of frozen credit availability and a deepening recession in Europe that may be exported to the U.S., China and the rest of the world. To many (ratings agencies, investors, etc.), the hopelessness of the European economic situation resembles a Franz Kafka work.

Fitch was particularly cheerless as following the EU Summit on Dec. 9-Dec. 10, the ratings agency concluded that a comprehensive solution to the eurozone crisis is technically and politically beyond reach. Despite positive commitments by EU leaders at the summit, particularly an acceleration in the creation of the European Stability Mechanism and downplaying the role of private-sector involvement, the concerns held by Fitch prior to the summit have not been materially eased. Fitch particularly emphasized the absence of a credible financial backstop and the need for a more active and explicit commitment from the ECB "to mitigate the risk of self-fulfilling liquidity crises for potentially illiquid but solvent members of the EU." While Fitch was upbeat that all 17 EU members have moved toward fiscal consolidation, it remained downbeat on the systemic nature of the crisis's impact on regional economic and financial stability in the short-, intermediate- and long-term time frames.

Last week, the IMF's managing director Christine Lagarde voiced similar concerns that Europe's economic and credit center will not hold.

Despite the anxiety in the markets and the downside risk to the world's economic growth entwined in the European debt crisis, I remain of the view that a credible plan to stem the debt crisis in Europe has just begun and that European and global leaders and central bankers will all come to their senses and intervene in a massive way.

Thus far ignored by the world's stock markets are some positive elements of the EU summit meeting, which, though slow-moving (should have been expected!), appear to have measurably taken tail risk off the table for Europe. The first steps of greater fiscal integration and sanctions against countries that violate agreed-upon debt and deficit rules have been taken and addressed. As a start, each of the 17 countries in the EU will introduce balanced budget amendments coupled with structural deficits capped at 0.5% of GDP (with cyclical deviations to 3% of GDP allowed). Automatic correction mechanisms will be triggered if member countries violate the debt and deficit rules.

Despite the (justified) gloom and doom in Europe, investors have ignored the mildly positive short-term action in sovereign debt yields last week. (At negative sentiment extremes, as was the case of the U.S. stock market in January 2009-February 2009, there is always disbelief at an inflection point of change.)

Ironically, European bond yields (excluding Italy's 10-year note) fell across the board and across the curve last week. Spanish two-year yields move to the lowest level in seven months, and yields have halved since November. France's two-year yield is the lowest in 13 months. According to Miller Tabak's Peter Boockvar, the euro basis swap and Euribor/OIS spread dropped last week. European economic statistics, too, were better than expected as reflected in a modest tick up in Germany's ZEW six-month expectations outlook and a slight improvement in the eurozone's manufacturing and services index (from 47 to 47.9).

One conclusion is becoming evident. The central banks of the world are continuing to coordinate their efforts to meet liquidity requirements under nearly every circumstance. They have determined that they must keep the functioning of the world's financial system unimpaired. To do that, liquidity has to increase, and the manner in which they accomplish this is to expand their balance sheets. A Lehman-type liquidity constraint will not be permitted to occur again if the central banks can avoid it.

In addition, on detailed examination of the balance sheets, you can see how the actions of the central bank on the asset side are balanced by rising reserve deposits on the liability side. In other words, a central bank goes into the market, buys a debt instrument or otherwise acquires an asset, pays for it or lends to a bank, and the bank then pledges it -- in any case, the central bank creates a reserve or cash that within hours is redeposited at the central bank as an excess reserve deposit. There is no credit multiplier in the monetary system when the newly created central bank money is circulated right back to the central bank.

Essentially, the commercial banks within each currency zone have excess reserves. They have excess liquidity, and they are electing to redeposit those reserves back with the safety of the central bank rather than do something else. That behavior reflects the uncertainty that exists throughout the financial system. For example, in the United States, a commercial bank can deposit excess reserves with the Federal Reserve and receive an annualized interest rate of 0.25% or 25 basis points. The commercial bank could do other things as well. In the United States, we see a very large sum reflected in the liabilities side of our chart stack, in a darker green color that shows the huge excess reserve deposit at the Federal Reserve. Banks in the U.S. are not engaged in the expansion of credit. They are redepositing their excess reserves at 25 basis points. The same thing is happening in most of the world. That is now apparent and easy to see in the color coding of the G4 central bank liability side of the balance sheets.

Liquidity, liquidity, liquidity. That is the theme by which the central banks are operating today.

Liquidity and solvency are two different issues. They should not be confused with one another. Greece remains insolvent as a sovereign country. In Europe and in the rest of the world, however, the insolvency is not being allowed to impart a liquidity crunch. The recent use of swaps and other vehicles to enhance liquidity continues to be expanded by the central banks of the world. Santa Claus is coming, and his name is Bernanke, Draghi, Shirakawa or King. Whether or not their noses are red remains to be seen.

In summary, the consensus view is that structurally swollen debt loads and the disparate (legal, political and economic) interests of the 17 members of the EU preclude a near- or intermediate- term resolution of the debt crisis. There is near unanimity that the recent timid-and-tame policy response will never be structurally capable or willing of adopting the necessary shock-and-awe resolution that the U.S. provided (as a template) two to three years ago.

My view is that the consensus might prove to be too pessimistic.

For now, the moves by the EU have not resolved the debt crisis, and the associated uncertainty will constrain the upside to risk markets. Nevertheless, with tail risk in Europe reduced, an improving domestic economic recovery, weak investor sentiment, reasonable valuations, decent corporate profit and dividend growth, a market-friendly Fed (joined by an easing of monetary policy by central bankers around the world), share prices can grind higher until more aggressive European policy is introduced (which I fully expect) in the form of non-EU countries pitching in.

In the fullness of time, I predict more aggressive policy, escalated sovereign debt purchases (see ECB President Mario Draghi's comments yesterday in Financial Times) and a broader country participation in the IMF will be forthcoming in response to the crisis in Europe.

Investors may want to own equities before these steps are implemented. For if the hapless Denver Broncos (of September and October) can launch its Tebow-style turnaround, so can the eurozone excoriate from the debt crisis by adopting more dramatic initiatives.