Reoccurring themes in the markets continued to play out again this week: the unemployment rate dropped to 5.9% – and labor participation didn’t change a bit; it’s still at 40 year lows. The International Monetary Fund (IMF) predicted lower global output warning “high debt, high unemployment…and mounting risks in the financial sector could spell years of weak growth” – yet European bonds went negative, a condition where lenders pay borrowers to borrow. Negative yields are a bad sign; they indicate an ass-backwards market – yet the stock market remains near all-time highs.
Let me try to make sense of things…
As mentioned in Danger Will Robinson, the European Central Bank (ECB) is enacting a charge to deposits held by large European banks. This move is intended to encourage lending by charging an expense to idle bank capital. In other words, put idle capital to work or pay a tax.
But the European economy stinks, as noted above by IMF managing director Christine Lagarde. Her comments substantiate the reason the ECB announced their plan to initiate a quantitative easing (QE) several weeks ago. QE is a move intended to strengthen banks.
So let me ask this: If European banks are weak (hence the need for them to be strengthened via QE) then why is the ECB forcing them to lower their capital reserves by charging them an expense on those same reserves?
When asked why Europe would adopt QE, Andrew Roberts, co-head of European economics at RBS, said “Italy is the reason…[their] economic weakness is deepening.” Yet Italy’s bond yields have dropped a stunning 63% since the last time they were bailed-out (2012), and they currently pay fractions less than the U.S.
How Italian bonds can be yielding 2.4% while the U.S. is paying essentially the same rate (2.45%) is nothing short of market dysfunction – a dysfunction that can only occur with over-reaching government intrusion.
Here’s how it happens…
Europe is in a no growth position and is again teetering on recession; job growth is dismal and free market activity is in such steady decline that deflation is a legitimate concern. For these reasons companies do not want to borrow – prospects are too bleak. And individuals aren’t borrowing as well – either they don’t’ want to borrow or cannot afford to do it.
Europe is in economic gridlock and money isn’t moving. That’s why the ECB is acting.
Unfortunately their actions will only make matters worse. Consider this…
Banks, now forced to put excess capital to work or face a charge, and with only limited free market options available, look to profit and cover their costs (the charge from the ECB) by lending it to sovereign States, like Italy. Italy’s current yield (2.4%) easily covers the charge imposed by the ECB (estimated to be a small fraction less than .25%.)
That’s what markets do; they inherently search to maximize profits. Profit, of course, is their goal and purpose. Besides, States like Italy are more likely to get bailed-out when the next mess hits the fan – especially with a QE program already in tact. In other words, sovereign debt produces more return with less risk.
Sound familiar?- Wait, there’s more…
The increased demand for sovereign State bonds forced by ECB policy is the driving force behind falling yields in the Euro Zone. Put another way, poor monetary policy is facilitating higher debt levels to entities that can’t rightfully honor their obligations – like Argentina, Portugal, and Italy, to name a few.
Ironic, isn’t it?- This is the same exact dynamic that occurred during the “subprime mortgage crisis” that produced the 2008 market crash. The only difference this time is that the lending isn’t happening to individuals unable to repay but Countries!
That’s a much bigger problem.
So many things point to history repeating itself. For instance, during the last debt-boom the yield curve was often inverted, where consumers realized a monetary benefit from taking more debt (even though they couldn’t pay it back) because interest rates were less than inflation. The same is true now in Germany, where yields have recently gone negative.
With demand being so great for international sovereign debt, Italy, like so many subprime mortgagers did during the housing-boom, has no problem taking on more debt than it could reasonably afford – at rock bottom interest rates.
So please tell me: Why should we believe that this monetary ponzi scheme won’t end with a worse kind of disaster as the last one? – especially knowing that the same exact things are being done now as then, albeit in a slightly different manner.
The next crash is going to be an ugly one because not just banks but countries will be failing. Central bankers will be unable to print the massive amounts of new currency required to avert disaster without wreaking inflationary havoc on the economy. That’s why gold remains a huge buy here – and I don’t care one bit it has taken it on the chin lately. That’s a total misnomer (see: Programmed Trading for more info.)
There’s an old saying, trade on speculation and invest on facts. The first is a short term perspective and the latter is a long term strategy.
Think long term, strategically, and…
Stay tuned…
