If you want to know where the global experiment in massive money printing is heading—-just take a look at the monetary madhouse in Europe. And that particular phrase has full resonance once again as it becomes more apparent by the hour that Europe and the Euro were not fixed at all. Indeed, beneath the surface of Draghi’s “whatever it takes” time out, the crisis has been metastasizing into ever more virulent deformations.
The coming European monetary crack-up is rooted in the fact that the ECB’s financial repression and ZIRP policies have—like everywhere else—-destroyed honest price discovery in Europe’s massive sovereign debt market. There is no other way to explain the preposterously low 10-year bond yields prevailing this morning for the various and sundry fiscal cripples that comprise the EU-19.
In the wake of Hollande’s two odd years of serial tax, regulatory and fiscal blows to his nation’s economy, for example, why not load-up on some French ten-year bonds at a yield of 0.78%? Yes, the French benchmark bond is now trading in Japanese style basis points, not the whole integers that French state debt has carried since the time of the Black Plague. Indeed, today’s miniscule yield is but a tiny fraction of the rates prevailing in more recent times, including the 3.5% rate at the bottom of the global financial meltdown in late 2008.
But never mind. What could go wrong that might possibly warrant a few hundred basis points more of yield in compensation for an investor’s risk? A skeptic might mention principal loss to inflation, credit risk owing to France’s headlong fiscal deterioration and, most especially, the possibility that the euro goes kaput and bondholders get paid in something else—say Madame Le Pen’s depreciating French francs.
Not to worry rejoins 78bps of yield. Apparently, inflation has been abolished once and forevermore—-implying that today’s razor thin nominal yield does not require headroom for principal erosion due to a higher price level. Yet the only evidence for that is a small downward blip in the French CPI since world oil prices began their plunge last summer, which resulted in a December y/y inflation rate of 0.5%.
But why would six months of aberration trump 15 years of truth. Namely, that the French CPI has risen at a 1.7% annually rate since 1999—-a trend not appreciably different than everywhere else in Europe and North America. Has there really been a financial regime change so profound and so certain that the graph below can be consigned to the dustbin of history; and that 100 years of persistent depreciation of the purchasing power of government money came to a screeching halt around August 2014?
Then there is the matter of actual fiscal risk. With each passing month the Hollande government’s duplicity with respect to its fiscal deficit targets becomes more blatant. It has now postponed for the third time its compliance with the EU treaty cap of 3% of GDP deficits, and, in fact, is on a fast track toward the 100% debt-to-GDP mark where the debt trap of big deficits and faltering growth becomes nearly irreversible.
Like much of Europe, France is patently loosing the debt trap battle. During the period since 2008 when its debt ratio has soared, its real GDP has barely inched forward, rising by less than 1% over 7 years.
And while France was clearly not growing its way out of debt, it was most definitely spending its way into an ever deeper fiscal crisis. State outlays have now reached 57% of GDP, and tower far above the already debilitating 46% of GDP that prevailed when Mitterrand’s socialist government first came to power in the early 1980s.
The larger point here is that France’s baleful fiscal numbers are not reflective of just a nettlesome business cycle or an incompetent government that can be replaced at the next election. The problem is structural, progressive and well nigh irreversible.
The Hollande regime is just the latest in a line of statist governments which have trifled with an ever expanding state budget through ad hoc tax increases rather than thoroughgoing reform of bloated entitlements and entrenched subsidies. Yet by confiscating more than 50% of the people earnings, it has only exacerbated France’s fiscal death spiral by throwing up new barriers to enterprise, human efforts, capital investment and sustainable economic growth.
And that gets to the biggest shibboleth of all embodied in today’s 78 bps yield. Namely, the hoary proposition that advanced nations like France do not default, and therefore there is no sovereign risk that needs to be funded in the bond yield.
That’s a whopper if there ever was one. In fact, France will eventually default—- either thorough re-emergence of euro inflation after a spree of ECB monetization of state debt or through “frexit” (French exit from the euro) if the Germans succeed in shackling the ECB’s printing presses.
Needless to say, today’s 78 basis point bid anticipates neither of these unavoidable outcomes. Instead, it is a complete artifact of central bank manipulation of the government bond market. It amounts to outsourced monetization of the state’s debt through the agency of hedge funds and fast money speculators who are front-running the ECB in the anticipation of selling these vastly overpriced securities back to Draghi come January 22nd. Call it forward monetization.
But here’s the thing. Whether the Germans fold or not later this month, today’s punters in French bonds are heading for a rude awakening. If the Germans do fold completely and permit the ECB to purchase upwards of one trillion of French, Italian, Spanish, Portuguese etc bonds, the sell-off in the euro will gather a powerful head of steam on its way to par with the dollar or even lower. In short order, the French CPI will be back in its historic 2% track or even higher.
Stated differently, after the fast money unloads its bonds into Draghi’s bid, the slower footed trend followers—especially the national banks which loaded up on their own countries’ rising sovereign debt after mid-2012—–will at length find themselves on the “offer” side of the market. Even the quasi-socialist banks and pension funds of Europe will not long sit on deeply negative real yields as far as the eye can see.
Similarly, in the more likely event that the Germans force a cockamamie compromise in the form of “QE lite”, where each nation’s central bank guarantees the credit risk on ECB purchases of its own sovereign debt, even the fast money will get clipped. The latter are betting that the French 10-year bond at today price of nearly 110 rests on the credit of Germany, not France. It will become re-priced in a nanosecond when the later becomes evident.
Finally, if the Germans remain unyielding on QE or if the ECB becomes paralyzed owing to the Greek elections and a subsequent standoff with Syriza demands for massive debt relief—–demands which would puncture a massive hole in the ECB’s balance sheet if met—-the sell-off will be fast and furious across the whole spectrum of French and peripheral country debt.
In fact, the Italian 10-year bond, which is yielding just 1.72% at present, would be even more vulnerable to a violent run. Again, the story is the same as the French case—except the fiscal metastasis is well more advanced. Italy’s economy today is no larger in real terms than it was in 1999. Yet it’s debt burden has marched steadily upward and is now beyond the point of no return.
At the end of the day, the implacable reality of these French and Italian fiscal time bombs means the end of the euro as it is currently constituted. The only intermediate term relief from a run on the trillions of French and Italian bonds now perched precariously behind the fast money “sell” button, is massive outright monetization. But that would mean a plunging exchange rate and resurgent inflation that would be intolerable to the Germans.
So Greece may usher in a far more destabilizing crisis than an outright “grexit” or a prolonged stand-off with respect to relief on its quarter trillion of debt owed to the EU institutions and the IMF. If it causes the ECB to hit the pause button on “whatever it takes” a profound demonstration on the consequences of false prices and false markets for sovereign debt will be immediately had.
When upwards of $7 trillion of French, Italian, Spanish and other peripheral debt go on offers, the Greek default will amount to a rounding error. And the euro will stumble toward an early demise.
Reprinted with permission from David Stockman’s Corner.
