Markets Rally on Hopes of Huge EU Bailout

  

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

In a replay of the 2008 Credit Crisis, global stock markets are now rallying strongly after a huge selloff last week. This pattern was common in late September and all during October three years ago. It seems to be replaying itself again in 2011. Huge moves down and up are common in severe bear markets.

As has happened many times so far, stocks are rallying on "hopes" of a resolution to the Greek debt problem and liquidity issues with EU banks. The Greek prime minister has stated confidently that Greece will definitely receive the next tranche of money from the first bailout and his comments got a lot of positive press attention. The mainstream press failed to inform the public that Greek officials have consistently made "misleading" statements during the debt crisis and their credibility might be considered questionable. The next payment from the first bailout has been delayed because Greece broke the promises it made for meeting fiscal objectives. Instead of listening to Greek officials, investors should consider that Greece has a CCC credit rating — the lowest sovereign debt rating in the world. If any country is going to default anywhere, it's Greece.

The numbers describing Greece's situation also speak for themselves and clearly indicate the inevitability of default.  Greece's debt to GDP ratio was 127% in 2009 in the early stages of the crisis. By the end of 2010, it was 143%. Reuters and a number of other sources report it as now around 160%. This rapid rise is taking place as Greece is getting €110 billion bailouts (the second one is in the works). Clearly the bailouts are not solving the problem, but merely slowing down an explosion of debt. Historically, once a country's debt to GDP goes over 150%, default seems to become inevitable.

The market keeps predicting default in Greece by setting astronomical interest rates. The one-year government bond had a yield of 138% on September 26th, down from its high of 142% on September 14th. Two-year debt was yielding 71% yesterday and the ten-year bond 24%. How can any entity pay these interest rates and avoid default?

All sorts of schemes are being discussed by EU leaders to handle the current crisis. There are rumors of a default plan that involves Greece paying back only half of its debt. EU officials described these rumors as just speculation, although in some cases the denials were less than firm. They also denied any enlargement of the EFSF (European Financial Stability Facility) — the EU's 440 billion euro bailout slush fund — was underway. The current global stock market rally got started when CNBC News reported that the EFSF would be leveraged up to eight-times and the European Investment Bank would issue bonds to buy up sovereign debt. The specific reaction to this report from one EU official was that it was "just bizarre". The big-money investing operations can make quite a bit of profits by planting "just bizarre" stories though because they can juice the markets up for a day or two. Then some bad news story appears and markets drop right back down. We've seen this pattern over and over again in the last two months.

At some point, the Greek debt crisis will be resolved. Until then, the EU will kick the can down the road as long as it can. At this point though, the can looks like it was run over by a freight train and then tossed around by a tornado. Greek debt holders will have to take a significant haircut on their debt and this means that banks in Germany and France will have to be recapitalized. Then something will have to be done to prevent the emerging defaults in Portugal and Ireland (both have already been bailed out once) and prevent the situation in Spain and Italy from getting bad enough to need a bail out. This will take a lot of money,  much more than the €440 billion in the EFSF.  Where will this money come from? It's quite simple — it will be printed.

Disclosure: None

Daryl Montgomery
Author: "Inflation Investing - A Guide for the 2010s"
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.

Liquidity Trap: The Global Collapse of Government Bond Yields

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


Government bond yields are dropping throughout the world. The U.S. 2-year, the German 5-year, 10-year and 30-year, and the French 10-year have all hit record lows recently. The Japanese 10-year is back below 1.0% and has fallen as low as 0.90%. The UK 10-year yield has been dropping for months and is only 17 basis points above its Credit Crisis low.

Record or close to record low yields on government bonds indicates enormous buying demand. Bonds hitting record low yields are by definition hitting record high prices. Moreover bond prices are going up when supply has undergone a tremendous expansion to pay for all the economic stimulus programs governments are running. So demand for government bonds has to be increasing faster than the rapidly growing supply if yields are falling. The obvious question is: Who is buying all of these bonds?

If yields were dropping in just one country instead of in almost everywhere, increased demand might be partially explained by countries with big foreign reserves like China buying more government debt. China has been a major purchaser of U.S. treasuries for a long time, but last month it sold about 3% of its holdings. Yet yields on long-term treasuries continued to drop, when they should have gone up. In the U.S., there has been enough buying to not only make up for the loss from China, but to purchase an even larger amount of bonds. There is only one possible source for funding for this demand for government paper in the U.S. and elsewhere on the planet and that is the national central banks and treasury departments.

Essentially, the central banks are 'printing' huge amounts of new money. This money goes into the financial system and gets recycled into purchasing government bonds and also stuck in the banking system as reserves. Most of the newly created money does not go into the real economy. It does allow governments to spend much more money than they could have ordinarily however, but most of this 'stimulus' actually goes for maintaining the status quo (with the objective of preventing further collapse) rather than for anything that would create growth in the future. So the economy stagnates, but holds up as long as the money printing ruse can be maintained. This is a liquidity trap and much of the global economy has already fallen into it based on the interest rate behavior of government bonds.

A liquidity trap is an ugly situation to say the least.  Either a country continues to spend its wealth to support its lifestyle until all of it is dissipated and complete impoverishment occurs or it finds a way to get some of the liquidity into the real economy. The problem is that only small measured amounts of liquidity can be allowed to flow into the economy in any given time period, but this is not the likely scenario. If the central bankers were capable of making this happen, they would have already done it. More likely is that the floodgates will be open and too much liquidity goes into the real economy too quickly. Hyperinflation will then occur and prices could start to skyrocket almost overnight. Japan has faced this situation for the last twenty years, now it looks like all the developed economies are going to be facing it.


Disclosure: No positions.

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.