We’ve warned for some time that the eurozone’s sure-to-fail muddle-through approach to its structural challenges was rattling investor confidence. Worse, its insistence on wearing an austerity hairshirt was not only committing Europe to deflation, but had high odds of sucking the global economy down along with it. Given how fragile the recovery is in advanced economies, and the magnitude of the debt overhang in many nations, a downturn could easily morph into a deflationary downspiral, potentially a full blown depression.
Let’s recap of some of the troubling sightings. First is that Spanish banks in particular, along with other Eurobanks, have been on the ECB drip feed for some time. Recall that the Spanish banking authorities pushed for the release of stress information on their banks precisely because they hoped that it would reassure the market and improve access to private funding. However, in a rather remarkable bureaucratic dedication to deadlines over common sense, the ECB is terminating a €442 billion one year liquidity facility on July 1 (FT Alphaville has been covering this intensively). An unknown but believed-to-be-large portion of the facility was used to fund carry trades within the EU, particularly that of Spanish and Greece sovereign debt (until spread widening late last year started burning fingers). To the extent it has been used to finance bank operations, the theory has been that banks would avail themselves of shorter-term ECB facilities, particularly its three month program.
Wellie, so that should not prove bothersome, right? Theory does not seem to have translated very well into practice. Europe opened badly on Tuesday, and the flight to safety continued in the US, with yields on ten-year Treasuries falling below 3%. There is also evidence of liquidity-hoarding, with an ECB sterilization operation going badly.The lousy US consumer confidence figures are the public face of considerable nervousness about the business outlook. For instance, despite the brave talk of recovery, corporate bond issues have fallen as companies increase cash levels rather than expand operations.
The ECB has retreated a tad in the face of the vote of no confidence from the markets, and will offer unlimited three month loans today, in advance of the termination of its one-year facility. More detail from the Financial Times:
Fears that the European Central Bank was scaling back emergency support to eurozone banks too soon sparked sharp falls in financial markets on Tuesday, with the euro tumbling to an eight-and-a-half year low against the Japanese yen….
“We will make sure that there are no problems and everything goes OK,” Christian Noyer, France’s central bank governor, told Europe 1 radio. But he warned that “there are some banks that are in a less good situation that might eventually suffer”.
Elena Salgado, Spanish finance minister, appealed to the central bank to take into account the liquidity needs of the Spanish banking system. She said on Spanish radio: “The ECB says it doesn’t like governments telling it what to do. I simply say I hope that on this occasion, as in others, the ECB will be aware of the needs of the Spanish financial system.”
Yves here. These visible signs of stress between national bank regulators and the ECB is not confidence-inducing, to say the least.
Ambrose Evans Pritchard pointed to other troubling indicators:
Triple tremors from the banking crisis in Spain, crumbling confidence in the US, and a setback in China’s leading economic indicator all combined with a vengeance on Tuesday. “The market in risky assets has capitulated today amid fears that the global recovery is petering out,” said Gavan Nolan, head of credit at Markit…
China’s Shanghai composite index of equities fell 4pc on Tuesday and is now 55pc below its peak in late 2008. The authorities have been tightening this year to slow inflation and curb property speculation as home prices in Shanghai and Beijing reach 13 times incomes, but it is unclear whether they can engineer a soft-landing in an economy where state-owned banks have built up huge hidden debts…
“Foreign capital flight is under way. This can only make matters worse given the climate of insecurity and the country’s lack of credibility,” said Borja Duran from Wealth Solutions in Madrid.
Spreads on Greek debt have jumped 350 basis points since the EU announced its plan in early May. Portuguese and Spanish yields have both jumped sharply despite direct action by the European Central Bank to force down yields. Private buyers are clearly dumping their holdings onto the ECB as fast they can.
Mr [Hans] Redeker [curency chief at BNP Paribas] said Japanese life insurers and institutional investors are slashing their estimated $700bn holdings of European debt. The funds are being recycled into yen, which reached ¥107 against the euro yesterday, the strongest in nine years.
Reader Swedish Lex early on had pointed to the importance of contagion spreading to Italy, and that is under way, per Evans-Pritchard:
The latest twist is a rise in credit default swaps on Italian debt, which jumped 16 basis points to 203 yesterday. An auction of Italian bonds this week went badly, with low bid-to-cover ratios….
Italy has been largely immune to Europe’s bond crisis until now, thanks to high savings…
Italy’s public debt is the third largest in the world after the US and Japan. Everybody knows that if the crisis ever reaches Rome, the game is up for monetary union.