In Between Days

by CC November 17, 2011 11:40 pm • Commentary


It’s not just Italy anymore. Spain’s borrowing costs are rising. French bond yields keep ticking ominously upward. The market conflagration is threatening to spread to all of Europe. Yet European leaders — especially German Chancellor Angela Merkel — still refuse to give their blessing to the European Central Bank to fire up the printing presses and start guaranteeing the debts of sovereign countries. Instead, E.U. officials have now resorted to dreaming up convoluted bailout schemes.
No bailout for you! (Odd Andersen/AFP) Earlier today, Reuters reported that European officials were noodling the idea of having the ECB lend money directly to the IMF, which would, in turn, prop up the debts of troubled countries like Italy and Spain. “It could be one way of getting around the legal restrictions on the ECB,” said one E.U. official. (Note: Plenty of experts don’t believe these legal restrictions on the European Central Bank even exist.) But even that Rube-Goldberg plan didn’t last very long, as Germany soon shot it down. And so we’re back to square one. Lots of chaos, no relief in sight.

In The Washington Post today, Michael Birnbaum reports that France and Germany are still at odds over how to solve the crisis. French officials are watching with horror as their once-low borrowing costs rise, and some French ministers are now suggesting that the European Central Bank needs to do its part to guarantee financial stability. “The best way to avoid contagion is to have a solid firewall” provided by the central bank, French Finance Minister Francois Baroin said.

German leaders like Merkel, on the other hand, have warned the ECB not to intervene too heavily, as officials are worried that a central-bank guarantee might take away incentives for countries like Italy to carry out fiscal and market reforms. In essence, Merkel said on Wednesday, Europe would be sacrificing long-term competitiveness for a quick fix.

“Still,” Birnbaum adds, “there are some signs that Germany’s position may be softening.

Credit Writedowns

In June, I wrote a post on the political economy of the European sovereign debt crisis, the thrust of which was as follows:

As some euro zone sovereign debtors are near insolvency, a liquidity crisis has begun in which various ‘creditors’, the various national taxpayers and bondholders, must fight to determine how to apportion the losses.

This is not a zero sum game, however, because the magnitude of the losses also depends on how various actors play their hands. For example, austerity decreases output and increases the likely losses. A unilateral default followed by panic and contagion would do so as well. The players know this and are trying to play their hand in order to maximize their own narrow interests.

This is the background issue. We live in a creditor-centric world and the way the political economy of this crisis has played out is in favouring the interests of creditors, as I predicted in that post. My conclusion at that time was that investors would have to avoid periphery sovereign debt – and boy have they. I also concluded that:

The point for policy makers is to socialise enough of the bank losses onto taxpayers in order to recapitalise the banks, survive the crisis and maintain the status quo. Taxpayers will accept this if the economy is robust enough.

And this is the rub. Now, the economies are really breaking down and panic has set in. You see pointless proposals to lord over supposed fiscal free riders from Finland and unelected governments lacking in political legitimacy and taking unfavourable economic policies in both Greece and Italy. Europe is clearly on the edge.

Looking forward, whether “the economy is robust enough” depends on the response of the ECB.


Asian shares fell for a fourth day in a row and the dollar firmed on Friday as Europe’s funding difficulties intensified, with Spanish borrowing costs hitting an unsustainable level and premiums for dollar funds rising further.

In a sign global funding strains may spread to Asia, benchmark three-month euroyen interest rates futures fell to an eight-month low on Friday on concerns that tightness in dollar money markets may prompt non-Japanese banks to raise yen at a higher rate.

Italy has pledged to embark on radical fiscal reforms to pull itself out of the debt crisis, but investor jitters remained firmly in place as euro zone governments struggle to raise funds and banks refrain from lending, seizing up market liquidity.


High-grade bonds fared better than most areas of the market today with one notable exception – the banks got crushed. And Jefferies Group, the financial sector whipping boy of the week, took the brunt of the selling, with its bonds dipping as much as 7% compared to just a 2% drop in the investment bank’s stock.

If you believe bond investors are the canary in the stock-market coal mine, this is cause for concern, if not flat-out panic, because Jefferies’s shorter term bonds sold off the most.

The brokerage’s 5.875% bonds due 2014 fell 7% to 85 cents on the dollar, pushing the yield of the bond to almost 13% from 9.5% on Wednesday, according to MarketAxess. The two-year bond now yields 2%-3% more than Jefferies’s longer term debt, a phenomenon called “yield curve inversion” that typically reflects doubts about a borrower’s ability to meet obligations.

Granted, the 2014 is relatively small at $250 million, making it easier to push around for anyone taking a bear run at Jefferies than the larger bonds at the end of its yield curve. But $55 million of the bond changed hands today, representing over 20% of the issue, which is a lot of paper to be explained by simple short selling.

 Tomorrow’s Tape- WSJ


At 8:15 a.m. ET, dovish New York Fed President Bill Dudley speaks again.

At 10:00 a.m., the Conference Board releases its leading indicators for October. Economists think they rose 0.6%, following a 0.2% gain in September.

At 1:50 p.m., San Francisco Fed President John Williams speaks.