The crisis in Europe is coming to a head. This can be measured by the overnight index swap (OIS) rate, which measures the floating risk between the central bank overnight rate and the swap or, insurance rate. The wider the spread is, the more concern there is regarding the borrower’s ability to repay the short-term loan.
This week we have also seen credit default swaps among the largest European banks move to new highs and yields on Spanish and Italian bonds have hit new highs above the previous July high water mark. Finally, risk is starting to spread as German, Japanese and Chinese credit default swap prices have run to the highest levels since the credit crisis of late 2008.
Meanwhile, the ongoing standoff between an economically strong Germany versus a crumbling Eurozone periphery has once again been prolonged. The joint action of the U.S. Federal Reserve bank along with the European Central Bank as well as those of Britain, Japan, Switzerland and Canada to ensure Dollar liquidity to European banks facing a credit crunch has simply provided market relief rather than issuing any type of resolution.
The Eurozone’s economic death spiral is beginning to affect other economies as well. China lowered its lending reserve requirement in an attempt to kick-start domestic demand in their economy and avoid a hard landing as their second largest market, the European Union is quickly heading into recession. The European Union is also responsible for the absorption of approximately 20% of our exports. Therefore, it is very likely that the severity of their recession will determine the likelihood of a recession here in the U.S., which I expect around the second quarter of 2012.
We’ve seen a huge shift in the global economic outlook between this summer and today. This summer’s revolutionary fires of democracy did not release the pent up demand for goods and services on the free market that was expected. North Africa, the Mediterranean and the Golden Crescent are still struggling to establish stability and develop a unified voice in the world’s financial markets.
The change in economic outlook is perhaps best viewed through the lens of international interest rate policies. This past June there were 18 global economies that either raised rates or were in the process of raising rates. More than 20% of them have completely reversed their position with more expected to follow by year’s end.
European banks are believed to own as much as $3 trillion in bad debt and be leveraged by as much as 40 to 1. Currently, this debt is carried on their books at face value. Even a small haircut would completely wipe out their lending reserves.
The joint venture by the central banks to guarantee liquidity is one more attempt to treat the symptom rather than the disease. The real disease is deflation. That’s right, deflation. The added liquidity that is fueling the rallies will not contribute to inflation until the economies of Europe, China and the U.S. can work through the excesses of the 2000’s. There is simply too much capacity in labor, production and capital to be absorbed by economies with declining employment.
The reality is that we’re going to see Dollars, Euros and Yen printed at alarming rates, as the only way to pay back the sovereign debts will be to print more currency. The repatriated currencies will be rolled into government debt, which will artificially suppress interest rates while artificially inflating other asset classes like food, energy and individual stocks. We will continue to race each other to the presses until we work through these excesses and then, lookout. Global inflation will hit like the late 70’s were just a warm-up.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.
