(Reuters) – “ Spain continues to study the price it will have to pay for seeking help from the European Central Bank’s bond-buying program but improved market conditions may make aid unnecessary, Prime Minister Mariano Rajoy said on Wednesday.

“I don’t know if Spain needs to ask for it,” Rajoy told parliament in a debate session, referring to an international rescue for Spain.

Yields on Spanish bonds have fallen dramatically, to five-month lows, since the ECB agreed last week to launch a new bond-buying program to reduce struggling euro zone countries’ borrowing costs provided they first request assistance from the euro zone’s rescue fund and abide by strict conditions.”

ECB will NOT buy Spanish bonds until Spain asks especifically for a Bailout.

Please Mr. Rajoy, stop daydreaming.

C Courtesy of John P.Hussman Late-Stage, High-Risk John P. Hussman, Ph.D. All rights reserved and actively enforced. Reprint Policy For investors who don’t rely much on historical research, evidence, or memory, the exuberance of the market here is undoubtedly enticing, while a strongly defensive position might seem unbearably at odds with prevailing conditions. For investors who do rely on historical research, evidence, and memory, prevailing conditions offer little choice but to maintain a strongly defensive position. Moreover, the evidence is so strong and familiar from a historical perspective that a defensive position should be fairly comfortable despite the near-term enthusiasm of investors. There are few times in history when the S&P 500 has been within 1% or less of its upper Bollinger band (two standard deviations above the 20-period moving average) on daily, weekly and monthly resolutions; coupled with a Shiller P/E in excess of 18 – the present multiple is actually 22.3; coupled with advisory bullishness above 47% and bearishness below 27% – the actual figures are 51% and 24.5% respectively; with the S&P 500 at a 4-year high and more than 8% above its 52-week moving average; and coupled, for good measure, with decelerating market internals, so that the advance-decline line at least deteriorated relative to its 13-week moving average compared with 6-months prior, or actually broke that average during the preceding month. This set of conditions is observationally equivalent to a variety of other extreme syndromes of overvalued, overbought, overbullish conditions that we’ve reported over time. Once that syndrome becomes extreme – as it has here – and you get any sort of meaningful “divergence” (rising interest rates, deteriorating internals, etc), the result is a virtual Who’s Who of awful times to invest. Consider the chronicle of these instances in recent decades: August and December 1972, shortly before a bull market peak that would see the S&P 500 lose half of its value over the next two years; August 1987, just before the market lost a third of its value over the next 20 weeks; April and July 1998, which would see the market lose 20% within a few months; a minor instance in July 1999 which would see the market lose just over 10% over the next 12 weeks, and following a recovery, another instance in March 2000 that would be followed by a collapse of more than 50% into 2002; April and July 2007, which would be followed by a collapse of more than 50% in the S&P 500, and today. The prior instances were sometimes followed by immediate market losses, and were sometimes characterized by extended top formations – which produce a sort of complacency as investors say “see, the market may be elevated and investors may be over-bullish, but the market is so resilient that it’s ignoring all that, so there’s no reason to worry.” Ultimately, however, the subsequent plunges wiped out far more return than investors achieved by remaining invested once conditions became so extreme. We are in familiar territory, but that territory generally marks the mouth of a vortex. Based on ensemble methods that capture a century of evidence – from Depression-era data, through the New Deal, World War, the Great Society, the electronics boom, the energy crisis, stagflation, the great moderation, the dot-com bubble, the tech crash, the housing bubble, the credit crisis, and even the more recent period of massive central bank interventions – our estimates of prospective market return/risk have been negative since April 2010 and have remained negative even as new data has arrived. Since early March, those estimates have plunged into the most negative 0.5% of historical instances. It’s worth noting that the S&P 500 posted a negative total return between April 2010 and November of last year. Of course, the market has also enjoyed a risk-on mode since then. Through Friday, the S&P 500 has achieved a total return of nearly 25% since our return/risk estimates turned negative in early 2010. Defensiveness has clearly been taxing in that respect. But this doesn’t remove the question of whether the market’s recent gains are durable, much less whether they will be extended. Corporate insiders certainly don’t seem to think so – their sales have tripled since July, to a rate of six shares sold for each share purchased. Far from being some novel “new era” environment, present conditions – rich valuations, overbought trends, lopsided bullishness, heavy insider sales, and lagging market internals – are part of a historical syndrome that is very familiar in the sense that we’ve repeatedly seen it prior to the worst market declines on record. But as the chronicle above should make clear, this doesn’t make our short-term experience any easier, because these conditions can emerge, go dormant for a few months while the market retreats modestly, and then reappear as the market registers a marginal new high. The ultimate outcome has historically been spectacularly bad, but it still takes patience and discipline to stay on the sidelines during late-stage, high-risk advances. Of course, the present instance may turn out differently than every prior instance has – it’s just that we have no basis to expect that outcome. Economic Notes The most interesting feature of last week’s “decision” by the European Central Bank was the continued eagerness of investors to hear what they want to hear, rather than what is actually said. With little doubt, what investors think they heard was that the ECB has finally decided to launch a new program by which it will begin purchasing Italian and Spanish debt in unlimited – unlimited – amounts, putting an emphatic end to European debt strains, and decisively ensuring the future unity of the Euro. Here is what the European Central Bank actually said: “A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.” If you wondered why Angela Merkel and the whole of Germany was not immediately up in arms, it is because prior to transactions by the ECB, the receiving country would have to submit to an adjustment program, ideally involving the IMF. This is nothing like what Spain has been asking for, which is for the ECB to make unconditional purchases. To benefit from the proposed OMT program, these countries have to subordinate their fiscal policy to outside conditionality. What if they don’t? “The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.” But assuming these countries accept the adjustment programs, at least they can be assured that the ECB will buy their debt in unlimited amounts, can’t they? “No ex ante quantitative limits are set on the size of Outright Monetary Transactions.” Read carefully – the ECB did not promise “unlimited” financing. Rather, it refused to specify an amount in advance (ex-ante), because it doesn’t want the markets to look at some inadequately small and fixed number and begin to speculate against the ECB as soon as that particular number is approached. By refusing to set a specific amount in advance, Draghi said in his press conference that he wanted the policy to be perceived as fully effective. But perception substitutes for reality only for so long. If Merkel, Monti and Rajoy were stranded on a mountaintop and Merkel was the only one with a bag of muesli, she might offer some to the other two without specifying an amount in advance, but there’s no doubt she’d be slapping it out of their hands if things got out of control. Finally, “The liquidity created through Outright Monetary Transactions will be fully sterilised.” This last provision is likely to both calm Germans and inflame them. Sterilization means that for every euro of Spanish or Italian bonds the ECB buys (creating new euros in the process), it will drain euros by selling some other security – most likely bonds of Germany, Holland, Finland, or other stronger European nations. This will help to calm Germans because it indicates that the overall supply of euros will not expand. It will also inflame them, however, because the existing stock of euros will now have been created to provide fiscal support to Spain, Italy and other troubled countries, while Germany, Holland, Finland and stronger countries will not have benefited at all from the money creation. It will be interesting how this plays on September 12, when the German Constitutional Court is set to decide on the legality of the European bailout funds, the EFSF and the ESM (technically, the Court will rule on an injunction against even passing it into law, but will not formally rule on constitutionality until possibly next year). My expectation is that they will rule that these mechanisms are in fact allowable and consistent with the German Constitution. Where it gets interesting is whether they will rule that it is allowable to leverage these mechanisms or operate with a banking license (which would make Germany’s existing contribution “capital” that could be wiped out, leaving Germany on the hook for much, much larger amounts – which essentially cedes fiscal authority from the German people to the ESM). I suspect that there is a fair chance that the Court will add language in their ruling to reject that possibility, which may force the idea of a “big bazooka” back to square one. We’ll see. — Here in the U.S., Friday’s August employment report was surprisingly weak relative to Wall Street’s expectations, though hundreds of thousands of workers abandoned the labor force, which allowed the unemployment rate to decline. Relative to our own expectations, the figure was elevated, as I expect that the August employment figure will ultimately be revised to a negative reading. This would be consistent with revisions that we’ve seen around prior recession starting points. For example, if you look at the originally reported data for May through August 1990, you’ll see 480,000 total jobs created (see the October 1990 vintage in Archival Federal Reserve Economic Data). But if you look at the revised data as it stands today, you’ll see a loss of 81,000 jobs for the same period. Look at January through April 2001, at the start of that recession. The vintage data shows a total gain of 105,000 jobs during those months, while the revised data now shows aloss of 262,000 jobs. Fast forward to February through May 2008, and though you’ll actually see an originally-reported job loss during that period of 248,000 jobs, the revised figures are still dismal in comparison, now reported at a loss of 577,000 jobs for the same period. As other good economic analysts have recognized, economic time series tend to be revised after-the-fact, with upward revisions in periods just before the recession begins, and downward revisions in periods just after the recession begins. I continue to believe that the U.S. joined an unfolding global recession, most probably in June of this year. — Ahead to QE3. A week ago, The Wall Street Journal ran a piece by Jon Hilsenrath titled Will Fed Act Again? Sizing Up Potential Costs. The article reviewed concerns about additional quantitative easing, noting that inflation has remained muted and the dollar has remained firm. Both of those outcomes were presented as evidence counter to Fed Governor Charles Plosser’s concern that “Without appropriate steps to withdraw or restrict the massive amount of liquidity that we have made available… the inflation rate is likely to rise to levels that most would consider unacceptable.” There is strong evidence to suggest that this is little but false comfort. While we don’t expect material inflationary pressures until the back-half of this decade, the Federal Reserve has increasingly placed itself into a position that will be nearly impossible to disgorge without enormous disruption. Specifically, the U.S. economy could not achieve a non-inflationary increase in Treasury bill yields to even 2% without requiring a nearly 50% reduction in the Federal Reserve’s balance sheet. This point is easily demonstrated in data from 1947 to the present. The relationship between short-term interest rates and the amount of monetary base per dollar of nominal GDP is very robust, and is widely recognized as the “liquidity preference” curve. We are already way out on the flat part of this curve. Note that Treasury bill yields have never been at even 2% except when there was less than 10 cents of base money per dollar of nominal GDP. There are only 3 ways to get there from the current 18 cents – dramatically cut the balance sheet, keep interest rates near zero for the nextdecade (assuming nominal GDP growth of 5% annually), or accept much higher rates of inflation than most would consider acceptable. Moreover, with a portfolio duration that we now estimate at about 8 years, historically low yields on Treasury securities, and a Fed balance sheet currently leveraged about 53-to-1 against the Fed’s own capital, an increase in long-term yields of anything more than 20 basis points a year would produce capital losses sufficient to wipe out interest income, making the Fed effectively insolvent, and turning monetary policy into fiscal policy. On the subject of Fed leverage, it is one thing to purchase long-dated bonds when yields are high. It is another to purchase them when yields are at record lows and very small yield changes are capable of wiping out all interest income and leaving the Fed in a loss position when it is already levered 53-to-1 (2.9 trillion of assets on 54.6 billion of capital, according to the Fed’s consolidated balance sheet). At a 10-year Treasury yield of just 1.6% and a portfolio duration of about 8 years (meaning that a 100 basis point move causes a change of about 8% in the value of the securities held by the Fed), it takes an interest rate increase of only about 20 basis points (1.6/8) to wipe out a year of interest on the portfolio held by the Fed and push it into capital losses. It would then take another 24 basis points to wipe out all of the capital on the Fed’s balance sheet. Of course, they don’t mark the balance sheet to market. So the public might not be aware of those losses, but that would only mean that we would have an insolvent Fed printing money on an extra-Constitutional basis to fund its own balance sheet losses instead of public spending. Based on a report from UBS (h/t ZeroHedge), the Federal Reserve now holds all but $650 billion of outstanding 10-30 year Treasury securities, with UBS warning “a large, fixed size QE program could cause liquidity to tank”, with a similar outcome in the event that the Fed pursues mortgage-backed securities instead. A couple of years ago, Bernanke asserted in a 60 minutes interview that “We could raise interest rates in 15 minutes if we have to. So there is really no problem in raising interest rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time.” Really? Tell that to Paul Volcker, who had to deal with enormous inflation at unemployment rates even higher and a monetary base dramatically smaller than we observe at present. The Fed now holds virtually no Treasury debt of maturity of less than 3 years, as Operation Twist and other efforts have been designed to force investors to choke on short-dated paper yielding next to nothing, in hopes of forcing them into riskier securities. The chart below shows the distribution of Fed holdings (dark bars) versus private sector holdings of Treasury debt, at various maturities. Of course, in equilibrium, someone still has to hold the short-dated Treasury securities, in addition to about $2.7 trillion in zero-interest cash and bank reserves, until those securities, currency, and reserves are retired. To believe that an unwinding of the Fed’s present balance sheet would not be disruptive is full-metal make-believe. Good economic policy acts to relieve some binding constraint on the economy. How does the Fed argue that base money is a binding constraint? At present, there are trillions of dollars held as idle reserves on bank balance sheets. While a “portfolio balance” perspective may well suggest that additional zero-interest reserves will force more investors into risky assets at the margin (which has been most effective after significant market declines over the prior 6-month period), so what? There is no historical evidence that changes in stock market value have a significant effect on GDP. Indeed, a 1% change in stock market value is associated with a change of only 0.03-0.05% in GDP, largely because individuals consume off of their expectation of “permanent income”, not off of transitory changes in volatile securities. In regard to why inflation has remained low, a useful way to see the relationship between the monetary base, interest rates, GDP and inflation is the “exchange equation”: MV = PQ, where M is base money, V is velocity, P is prices, and Q is real output. As is evident from the liquidity preference chart, base velocity (PQ/M) is tightly related to short-term interest rates. In fact, as long as short-term interest rates fall in response to increases in the monetary base, those increases have virtually no effect on real output, but instead translate almost directly into declines in velocity. Again, some data from 1947 to the present: If the decline in velocity exactly offsets the increase in base money, inflation is not going to explode overnight. But this happy outcome is brought to you by the passive response of short-term interest rates and the willingness of the public to accumulate zero-interest assets, which is in turn the result of strong and legitimate concerns about credit risk, default risk, and economic weakness. But remove any of those factors, or allow any other exogenous upward pressure on short-term interest rates, and the result will be upward pressure on velocity. Barring enormous rates of real GDP growth, the only way to counter that, as the first chart suggests, will be through either massive (and potentially disruptive) contraction of the Federal Reserve’s balance sheet, or acceptance of undesirable rates of inflation. As hedge funds often discover, and JP Morgan recently learned, it is very easy to get into a position that later turns out to be nearly impossible to exit smoothly. A significant reduction in the Fed’s balance sheet is unlikely to be achieved at long-term interest rates nearly where they are now, which implies capital losses on the Fed account, which implies that in contemplating a further round of quantitative easing, the Federal Reserve is effectively contemplating a fiscal policy action. Unfortunately, they’re likely to do it anyway. From an investment perspective, it’s important to consider the potential effect of additional quantitative easing. As I noted several weeks ago (see What if the Fed Throws a QE3 and Nobody Comes?), the effect of prior rounds of quantitative easing both in the U.S. and abroad has generally been limited to little more than a recovery of the loss that the stock market sustained over the prior 6-month period. Presently, the S&P 500 is at a 4-year high, valuations are rich on the basis of normalized earnings, and advisory sentiment exceeds 50% bulls – over twice the number of bearish advisors according to Investors Intelligence. In recent years, each round of QE emerged closely on the heels of a significant market loss that produced a spike in risk premiums. In that environment, expanding the stock of zero-interest rate assets had the effect of bringing those risk premiums back down to those observed over the prior 6-months or so, and more recent interventions have shown diminishing returns. At present, risk-premiums are already depressed and there is no 6-month loss to recover. In short, even the evidence of the past several years does not support the automatic assumption that stock prices will advance in the event of another round of QE at present levels. With little doubt, the market is likely to enjoy some immediate cheer from that sort of move, particularly if the Fed refrains from providing a specific ex-ante limit on its purchases – allowing investors to rejoice in the perception that the Fed had launched “unlimited” QE. Still, that cheer may be short-lived. If we examine the way that QE actually operates, and how and why risk premiums have responded to prior rounds, it is entirely unclear that a further round will have much effect beyond an initial spike of enthusiasm. That is, unless one adopts a superstitious faith that stocks will rise in response to QE, since QE makes stocks rise, because QE equals stocks rising, with no further analysis needed. The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds. Fund Notes As of Friday, our estimates of prospective return/risk in the stock market remain in the most negative 0.5% of historical instances. Notably, the S&P 500 is within 1% of its upper Bollinger band (two standard deviations above its 20-period moving average) on daily, weekly and monthly resolutions. According to Investors Intelligence, bullish advisors outnumber bearish advisors by more than two-to-one (51% vs. 24.5% respectively), and corporate insiders are selling stock at a pace of six shares sold for every share purchased. On the valuation front, profit margins remain elevated and the ratio of corporate profits to GDP is nearly 70% above its historical norm, and as a result, price/earnings multiples that are based on near-term earnings estimates are elevated, but do not seem extreme. But stocks are not a claim on one year of earnings – they are a claim on a very long-term stream of cash flows that will actually be delivered to investors over time. On the basis of normalized earnings, we estimate a 10-year prospective total return for the S&P 500 of less than 4.5% nominal. The Shiller P/E is presently 22.3, which is in the richest 5% of all historical data prior to the late-1990’s bubble. While this multiple may not seem extreme relative to the data of the past 13 years or so, it should be remembered that stocks have lagged Treasury bill yields during this period, and the market has experienced two separate plunges in excess of 50% each, precisely because valuations have been so rich. The market conditions we observe at present are very familiar from the standpoint of historical data, matching those that have appeared prior to the most violent market declines on record (e.g. 1973-74, 1987, 2000-2002, 2007-2009). That is no assurance that market losses will be swift, as some of those instances included extended tops characterized by some amount of “churn” and exhaustion before failing. Indeed, even the historical record of these instances is not an assurance that stocks will decline at all in the present case. It’s just that we have no other basis to form expectations about prospective return and risk except to understand how valuations, market action, sentiment and other factors have converged to drive market returns over history. In any event, we are creatures of discipline, and I strongly believe that our discipline is well-suited to achieve our investment objectives over the complete bull-bear market cycle, despite what will inevitably include shorter-term frustrations. Meanwhile, long-time readers of these weekly comments may be somewhat relieved that going forward, I’ll simply refer to our 2012 Annual Report to elaborate on why the recent cycle has been an outlier, compared with the full-cycle performance that we achieved prior to 2009, and that I expect in future cycles. There will be periods where a few of our large holdings get hit (as we saw on Friday) despite the fact that our stock selection has strongly outperformed the S&P 500 over time. There will be periods where we are defensive in an advancing market because we face familiar sets of market conditions that have been devastating for investors, as we do now. But what matters to our strategy, and what produces strong risk-adjusted returns over the complete market cycle, is the habit of accepting greater risk in conditions where risk has generally been well-rewarded, and avoiding risk in conditions where risk has generally been punished. We are now in a very familiar environment that has regularly punished risk-taking severely, if not immediately. Strategic Growth remains fully hedged, with just over 1% of assets invested in additional option time premium to raise the strike prices of the put option side of our hedge, looking out to the end of the year. Strategic International remains fully hedged. Strategic Dividend Value remains hedged at 50% of the value of its stock holdings – its most defensive position. In Strategic Total Return, we used recent bond market strength to cut our portfolio duration to 1.4 years (meaning that a 100 basis point change in interest rates would be expected to affect the portfolio by about 1.4% on the basis of bond price changes), and we cut our exposure in precious metals shares to about 6% of assets, as the prospect for open monetary spigots is likely to be far more limited than investors seem to expect, and global economic activity is slowing rapidly, now including China and other presumed economic bulwarks. Our return/risk estimates remain positive in that sector, but have become much more muted in response to the recent price advance and other factors. The Fund continues to hold small allocations in utility shares and foreign currencies.

INET COUNCIL ON THE EURO ZONE CRISIS

It is still possible   economically and politically to find a way out of the euro zone crisis if policy makers separately address two  problems:  dealing with the  legacy  costs of  the  initially flawed design of  the euro  zone,  and fixing the  design  itself. The  former  requires  significant  burden sharing  and an  economic  strategy  that  focuses on  stabilising  the  countries  that  are  suffering from  recession  and  capital  flight.  In  contrast,  fixing  the  design  requires  a  financial  (banking) union with strong euro+area institutions and a minimal fiscal backstop.

http://ineteconomics.org/sites/inet.civicactions.net/files/ICEC_Statement_23-7-12.pdf

 

TRIPLETE EUROCOPA, MUNDIAL Y EUROCOPA… Y AHORA A BRASIL

Courtesy of George Soros

Proposal for a European Fiscal Authority (EFA), a Debt Reduction Fund and European Treasury Bills

Rationale

In retrospect it is now clear that the member states entered the monetary union that was incomplete in its construction.  The main source of trouble is that the member states surrendered their right to print money to the ECB without fully realizing what that entails- and neither did the European authorities. When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank discounted all government bonds on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker countries to earn a few extra basis points. That is what caused interest rates to converge.  The large fall in the cost of credit helped fuel housing and consumption booms, which went unchecked.  At the same time, Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive.  This led to a wide divergence in economic performance.

Then came the crash of 2008 which created conditions far removed from those prescribed by the Maastricht Treaty. Governments had to bail out their banks and some of them found themselves in the position of a third world country that had become heavily indebted in a currency that they did not control. Due to the divergence in economic performance Europe became divided into creditors and debtors countries.

When financial markets discovered that supposedly riskless government bonds may actually be forced into default they raised risk premiums dramatically. This rendered commercial banks whose balance sheets were loaded with those bonds potentially insolvent. That gave rise to an adverse feedback loop between the solvency of the banks problems of the banks and the risk premium on sovereign debt.

The Eurozone is now replicating how the global financial system dealt such crises in 1982 and again in 1997. Then the international authorities inflicted hardship on the periphery in order to protect the center; now Germany is unintentionally playing the same role. The details differ but the idea is the same: the creditors are shifting all the burden of adjustment onto the debtors and the “center” avoids its own responsibility for the imbalances. Interestingly, the terms “center” and “periphery” have crept into usage almost unnoticed. Yet in the euro crisis the responsibility of “the center” is even greater than it was in 1982 or 1997: they were the architects of a flawed currency system and failed to correct its defects. In the 1980’s Latin America suffered a lost decade; a similar fate now awaits Europe.

At the onset of the crisis a breakup of the euro was inconceivable: the assets and liabilities denominated in a common currency were so intermingled that a breakup would have led to an uncontrollable meltdown. But as the crisis progressed the financial system has been progressively reordered along national lines. This trend has gathered momentum in recent months. The LTRO enabled Spanish and Italian banks to buy the bonds of their own countries and earn a large spread. Simultaneously banks are giving preference to shedding assets outside their national borders and risk managers are trying to match assets and liabilities within national borders rather than within the eurozone as a whole.

If this continued for a few years a break-up of the euro would become possible without a meltdown but even then the creditor countries would be left with large claims against the debtor countries which would be difficult, if not impossible, to collect. In addition to all the rescue packages and ECB interventions the central banks have large claims against the central banks of the debtor countries within the Target2 clearing system. The Bundesbank had claims of €644 billion on April 30th and the amount is rapidly growing due to capital flight.

The creditor countries led by Germany are always willing to do what is necessary to avoid a cataclysm. But that is not enough to resolve the crisis so it continues growing. Tensions in financial markets have risen to new highs. Most telling is that Britain, which retained control of its currency, enjoys the lowest yields on government bonds in its history while the risk premium on Spanish sovereign debt is at a new high despite Spain’s deficit and debt to GDP ratio being lower than those of the UK. The real economy of the Eurozone as a whole is declining while Germany is still booming. This means that the divergence between debtors and creditors is getting wider. The political and social dynamics are also working toward disintegration.  Public opinion as expressed in recent election results is increasingly opposed to austerity and this trend is likely to grow until the policy is reversed.

What is needed is a set of bold initiatives that are convincing enough to persuade both the public and the financial markets that the authorities have both the will and the resources to make the euro work. These initiatives have to conform with the existing Treaties yet they have to be bold enough to bring conditions back closer to those that were prescribed by Treaties. The Treaties could then be revised in a calmer atmosphere so that the current excesses will not recur.

It is difficult but not impossible to construct a set of initiatives that will meet these tough requirements. They would have to simultaneously tackle the banking and the sovereign debt problems without neglecting to reduce divergences in competitiveness. There are various ways to provide it but they all need the active support of Germany as the largest creditor country.

At the Rome meeting on Thursday June 22 the four heads of state agreed on steps towards a banking union and a modest stimulus package to complement the fiscal compact but Chancellor Merkel resisted all proposals to provide relief to Spain and Italy from the excessive risk premiums prevailing in the market. This threatens to turn the June summit into another fiasco which may well prove fatal because it will not provide a strong enough firewall to protect the rest of the eurozone against the possibility of a Greek exit. Even if a fatal accident can be avoided the divisions between creditor and debtor countries will be reinforced and the “periphery” countries will have no chance of regaining competitiveness because the playing field is tilted against them. This may serve Germany’s narrow self-interest but it will create a Europe that is very different from the open society that fired people’s imagination. That is not what Chancellor Merkel or the overwhelming majority of Germans stand for.

Chancellor Merkel argues that it is against the rules to use the ECB to solve the fiscal problems of member countries and she’s right. President Draghi of the ECB has said much the same. There is a missing element in the current plans and this proposal is designed to provide it.

The Proposal

The June summit has to produce a Political Declaration which outlines not only the long-term vision of a political union but also practical steps towards a fiscal and a banking union. Since plans for a banking union are well advanced this proposal is confined to:

•        A European Fiscal Authority (EFA) which will serve as the embryo of the fiscal union and also provide fiscal backing for an embryonic banking union.

•        A Debt Reduction Fund (DRF) which will provide immediate relief to the periphery countries on refinancing their sovereign debt by issuing European Treasury Bills.

These measures will require an Intergovernmental Agreement. With unanimity at the summit the process could be accelerated and, on the basis of the Political Declaration, some steps could already be taken in the meantime. This would bring immediate relief to the financial markets and reverse the political dynamics from conflict to cooperation.

This is how it would work.

European Fiscal Authority (EFA): To be established by inter-governmental treaty a.s.a.p.

Membership: Finance Ministers of Eurozone countries

Organization: Embryonic European Treasury

Voting: According to shareholdings in ECB                                                                       

Majority

•        80% when guarantees are involved that disproportionately affect creditor countries

•        50% plus when members are affected proportionately

Mission

1.      Implement Debt Reduction Fund – a modified form of the European Debt Redemption Pact that has been proposed by the German Council of Economic Advisors.

2.      Provide fiscal backing for banking union.

3.      Assume solvency risk on government bonds held by ECB.

4.      Provide financing for a growth policy to complement the fiscal compact.

5.      After a suitable transitional period allow for annual settlement of Target2 balances.

Financial resources

1.    Control of ESM, EFSF

2.    One tenth of 1% additional VAT contribution from member states- approved by 80% majority.  This will demonstrate the political will necessary to carry out the mission.

3.   Additional financial resources: to be mobilized as needed.

The Debt Reduction Fund

The EFA will conclude agreements with individual countries that will oblige them to abide by the fiscal compact and introduce specific structural reforms like labor market liberalization and pension reforms. In return the EFA would reduce that country’s stock of debt to 60% of GDP or such higher figure as the agreement specifies by acquiring bonds in 1) primary market 2) secondary market and 3) from the ECB and other official bodies.

The EFA will finance its purchases by issuing European Treasury Bills and pass on the benefit of cheap financing to the country concerned. The bills will be assigned zero risk rating by the authorities and will be treated as the highest quality collateral for repo operations at the ECB.  The banking system has an urgent need for risk-free liquid assets. Banks are currently holding more than €700 billion of surplus liquidity at the ECB earning only one quarter of 1% interest.  This assures a large and ready market for the bills.

Should a participating country subsequently fail to live up to its commitments the EFA may impose a fine or other form of penalty which would be proportionate to the violation so that it would not turn into a nuclear option that cannot be exercised. This would provide strong protection against moral hazard. For instance, it would make it practically impossible for a successor government in Italy to break any commitments undertaken by the Monti government.  Having practically half the Italian debt financed by European treasury bills will have an effect similar to a reduction in the average maturity of its debt.  That would make a successor government all the more responsive to any punishment imposed by the EFA.

Only after the demand for European treasury bills has been exhausted will the EFA consider issuing longer-term bonds.   After a transitional period long enough to insure that the Eurozone resumes growth, the participating countries concerned will enter into a debt reduction program which will be tailored not to jeopardize their growth. That will be the prelude to the establishment of a full fiscal union with the appropriate political arrangements which, in turn, will allow the replacement of the remaining 60% of sovereign debt by Eurobonds.

A Euro Area Banking Union

By taking control of the ESM and the EFSF, the EFA would be able to provide the necessary fiscal backing for a banking union. The EFA as a political authority acting in partnership with the ECB can do what the ECB as a monetary authority cannot do on its own.

A banking union has to have three components

1. A European source of funding for recapitalizing the banks

This could be provided by the ESM acting under the control of the EFA.  While the ESM has substantial resources that could be used for this purpose, allowing it to borrow from the ECB would substantially reinforce it.  It would require a banking license for the ESM, best provided by a modification of the Intergovernmental Agreement.  This is highly desirable but not critical for the plan to work.

2. Eurozone-wide supervision and regulation of banks – this is best provided by the ECB acting together with the European Banking Authority.

3. A Eurozone-wide deposit insurance scheme. This is the thorniest immediate problem. German depositors are reluctant to pay for the extra risk posed by Spanish banks in the current economic climate and German taxpayers are unwilling to make up the difference. But the EFA assuming the solvency risk on government bonds held by the ECB provides a makeshift solution. Specifically, the EFA could take over the Greek bonds held by the ECB coming due on August 20th and thereby avoid a Greek default. The ECB could then continue to provide unlimited liquidity to the Greek banks which have recently been recapitalized. This would not eliminate capital flight but it would remove the most immediate threat confronting the euro-area – a run on the banks of other periphery countries.  A more lasting solution will have to await the formation of a full-fledged banking union. The EFA taking over the solvency risk on the bonds held by the ECB would establish the principle that the EFA is responsible for solvency risks and the ECB for providing liquidity.

Growth Policy

By laying the groundwork for a banking union and substantially reducing the financing costs of sovereign debt, the June summit will offer an escape route from the deflationary debt trap in which the European Union is currently caught. Nevertheless, it would be highly desirable to develop a growth policy to accompany the fiscal compact.  This could form part of the Political Declaration but time is too short to go into details.  The Political Declaration could point out that the EFA is providing the institutional framework for developing a growth policy.

Annual Settlement for Target Balances

Similarly, the Political Declaration could contain a paragraph announcing that after an appropriate transitional period Target2 balances would be annually settled.  This would be a reward to Germany and other creditor countries for their willingness to provide the guarantees implied by the issuance of European treasury bills.

Creditor countries should remember that they have made practically no transfer payments; they have only made loans which will result in losses if they are not repaid.   The proposals outlined here to are comprehensive enough to reduce the likelihood that any losses will be incurred.  The more complete the guarantees the less likely they are to be invoked.

Sequencing

Immediately – at June summit issue a Political Declaration and set in motion and Intergovernmental Agreement establishing the EFA with the appropriate powers to carry out its mission.

Very short term – in anticipation of Intergovernmental Agreement

•        ECB starts accumulating Italian and Spanish bonds.

•        ESM takes over ECB’s holdings of Greek bonds insuring the ECB against default risk.

•        No implementation of austerity measures as long a country has negative GDP growth rate.

•        Finance Ministers start negotiating structural reforms that will qualify “periphery” countries to benefit from debt reduction scheme.

Short term – hopefully before year-end

•        Ratify and implement new Intergovernmental Agreement.

•        Develop growth policy.

Medium term – next 3 to 5 years

•        Creation of fiscal, banking, and political union.

from Sober Look by Walter Kurtz

(Reuters) – Italy should consider leaving the euro unless Germany agrees to the European Central Bank acting as a guarantor for sovereign debt and printing money to reflate the economy, former Prime Minister Silvio Berlusconi said on Wednesday.

“Leaving the euro is not a blasphemy,” he wrote on his Facebook page.

If Germany does not agree to a new role for the ECB then it should consider leaving the euro itself, Berlusconi said. “I have spoken to some German experts who would be in favor,” said Berlusconi, leader of one of two main parties backing pro-European Prime Minister Mario Monti.

Earlier, at a book presentation, Berlusconi was more explicit about the prospect of a return to the lira.

“What would happen if Italy, Spain or Greece went back to their old currencies? I don’t know, maybe there would be a loss of wealth but I don’t understand why,” he was quoted as saying by Italian news agencies.

The 75-year-old media magnate, whose People of Freedom party (PDL) lost heavily in local elections last month and has been shedding supporters steadily over the last year, is increasingly targeting the euro in a bid to regain popularity.

On June 1, he made very similar comments on the ECB and Germany and said Italy’s central bank should begin printing euros or printing lira to help Italy out of recession, only to say the following day that his remarks were a “joke”.

With less than a year before the next general election, Italy faces the prospect of at least two large parties running on an anti-euro ticket.

The Five Star Movement led by comedian Beppe Grillo, who urges an exit from the euro, has overtaken the PDL according to recent polls to become Italy’s second largest party, with more than 20 percent of voter support.

The pro-devolution Northern League also often expresses skepticism or hostility about the single currency.

Spain has had many episodes of yield spikes. Let´s not forget History. It will be good for younger ( and not so young ) generations to have a little bit of perspective

The 10yr Bond yield reflected investor fears in : 1820, 1831, 1834, 1851,1867, 1872, 1882,1936 & 2012

 

Source: Global Financial Data

Courtesy of John Mauldin

Federalism, Debt Traps and Competition

By Charles Gave

At times I have this feeling that I am living on a different planet than most economic commentators. Everyone is waiting to see if Germany will bite the bullet and mutualize the EMU’s debt—thus saving the euro. Not only will this not work, but it would make the situation even more unmanageable, by papering over what are essentially debt-trap situations for a number European countries. The only escape for these struggling countries is through a growth-boosting improvement in competitiveness, which cannot be done under a monetary union.

Let us take the example of Italy:

Italy’s economic growth has stagnated since entering the euro, yet its debt load has grown apace. Now heading into its fourth recession in 10 years, the country will see tax receipts collapse as automatic stabilizers kick in, and as a result its budget deficit will magnify. This will push the cost of capital up even higher, which in turn will depress growth further—the classic vicious cycle of a debt trap. We are seeing this quagmire not just in Italy but in many of the troubled EMU economies, including Spain.

Why is Italy in a debt trap? The answer is deceptively simple: Italy is not competitive. From 1982 to the euro’s start in 2000, German and Italian industrial production expanded at the same growth rate. However, as the chart overleaf underlines, rebasing the German industrial production index to 2000, we see it has moved from 100 to 111 while Italy’s IP index shrunk from 100 to 76. Italy is clearly having a harder time competing against Germany since they joined a common monetary union.

The explanation of this phenomenon can partly be explained by the next chart. In the past, the Italians could devalue now and then to increase productivity vis-a-vis the Germans. Without this option, Italy’s real labor productivity has sorely lagged Germany’s—i.e., the Germans are getting more bang for every “euro” buck.

With lower productivity and a higher cost of capital, one would have to be brain dead to put a factory in Italy, especially if one knows that the tax rate in Italy is going to go up to try to close the budget deficits (as if a tax increase ever led to a reduction in the deficit!). Needless to say, the financial markets have perfectly anticipated this state of affairs and expect the unavoidable re-emergence of the lira.

Please have a look at this graph:

Based on current 10-year sovereign prices, the chart tells us what the market is willing to pay for 10-year zero bonds of Germany and Italy. The difference between the two lines (see next chart) is about 32%—which means a 32% devaluation is already priced into the market.

The marvelous thing is that the expected devaluation and or write-off of the debt also can be seen as pricing in differences in labor costs.

Enter federalism

 

Let us explore now the possibility that Germany and other EMU hold- outs agrees to accept joint responsibility for all EMU debt. Then one would expect the German and Italian rates to converge again towards an average of roughly 4%, which has been more or less constant for the best part of the last 14 years, and with a very small standard deviation:

This would imply a massive bull market in Italian bonds and a massive bear market in German bonds. Since the German banks are already not very robust, they need a quasi collapse in the German bond market like a hole in the head.

However the decline in Italian yields to 4% would solve none of the Italian problems.Most crucially, it would not solve the key issue of lack of competitiveness against EMU powerhouses like Germany. Italy will not be able to grow itself out of its current bind under the yoke of currency which is overvalued for a country like Italy. Which means the structural growth rate will never catch up with the cost of capital — Italy might still have to write-off some of its debt.

And keep in mind—Italy is a country that will have its cost of capital lowered by debt mutualisation. A country like France will be much worse off as its cost of capital rises by at least like 150 bp at a time when she is also heading into a recession—drastically lowering the odds that France can escape a debt trap.

With German yields rising, one could probably say goodbye to the bull market in real estate in Germany and with three of its main clients going under one should start worrying about Germany too.

I am flabbergasted. Why would anybody believe that a federalization of the debt is a solution to the Euro crisis is beyond my understanding? Such a move would make the economic and financial situation far worse than it is today for almost every player, Italy , France, Germany Spain, Portugal.

Unfortunately, since it is at the same time idiotic and counterproductive, I fully expect the European elites to try to and go for it. If so, I would recommend selling across the board in Europe—currencies, bonds, equities—and become very cautious on the rest of the world.

My only hope is that the markets and the Greeks will stop this new suicidal move. Let’s wait for the Greek elections and hope for the bad guys to win.

Courtsey of John Mauldin

Macro-EU: The Solution Illusion

Weldon’s Money Monitor

May 23, 2012

“Dating all the way back to the day the Greek Drachma was accepted into the EU’s ERM (Exchange Rate Mechanism), thus retiring Greece’s currency, and replacing it with the Eurocurrency … we have always believed that a two-tier Eurocurrency ‘regime’ would ultimately ‘reign’, once the EUR experiment failed.

We envisioned that the northern ‘core’ countries such as Germany, France, the Netherlands, Belgium and Austria would represent the ‘first tier’ EUR countries, while the southern, more indebted non-core nations, including Greece, Spain, Portugal, and Italy, would represent the ‘second tier’.

Within the last two years we have abandoned that thought-process, as the ‘core’ itself has disintegrated, amid a deepening debt-deficit crisis in France, Belgium, Austria and the Netherlands (more of a macro-political crisis in the latter, than a sovereign debt issue).

Indeed, as we have repeatedly stated since 2009 … 25 of the 27 EU member nations, including both France and Germany, are in violation of the Union Treaty defined (allegedly) ‘hard caps’ for debt, or deficits, or both.

For sure, the tectonic political shift in France puts their top-credit-rating status at greater risk … and with it, their position as a ‘core’ nation.

We have already exposed Belgium and Austria for the egregious level of their sovereign debt, relative to their respective populations … levels that are, on a relative basis, larger than the debt of Italy.

As for the countries in the south …

… Spain is already in crisis, on ALL fronts, the sovereign debt front, the political front, the banking sector front, the housing-labor-deflation front, and the macro-economic front as it applies to domestic final demand …

… while Italy is becoming increasingly desperate in their effort to stave off a bond market crisis.

Portugal is not as indebted as the other second-tier countries, but their banking system is less secure, and their bonds have gotten crushed.

And then there is Greece.

In April of 2010 we ‘penned’ the first of a trilogy of Money Monitors focused on Greece, using the “Titanic” theme.

As the ship (Greece, and their participation in the EUR) continues to sink, the options as it pertains to actions that might represent a “solution” to the Greek situation, can be whittled down to a simple choice between two courses of action:

— Greece leaves the EU, and brings the Drachma out of retirement

— EU officialdom does whatever it takes to keep Greece in the EU, to avoid setting a precedent that could ‘spread’ to Portugal and Spain, sparking a debate about a return to the Escudo and Peseta.

Seemingly, either solution is merely an illusion, as neither is likely to ‘work’.

But what if everyone is looking at this from the wrong ‘angle’ ???

What if there is an optical illusion dynamic here that is keeping officialdom from ‘seeing’ an alternative ‘solution’ ???

Indeed, we cannot help but think of the old ‘optical trickery’ offered by the ‘image’ on display below, picturing one of two possible ‘visions’.

From the most often observed perspective, the picture is an older woman facing to the left, with a witch-like profile, and wearing a shawl.

Indeed, the vision of the old woman represents Greece.

In terms of the EU crisis, the vision of the old woman represents Greece leaving the EUR and going ‘old-school’, by bringing back the Drachma.

But there is an alternative ‘vision’ to be gleaned from within the picture shown above … that of a young woman, with dark hair and a perky little nose, facing left and away from the front and wearing a choker (which also serves as the thin lips of the old woman).

The young woman represents an alternative ‘vision’.

In terms of the European crisis, the young woman represents an alternative ‘solution’, one that does NOT include reviving the Drachma.

Indeed, if the Drachma were revived … eventually, there would be a similar need to bring the Spanish Peseta and the Portuguese Escudo out of retirement too …

… followed by the Italian Lira, and perhaps even the French Franc.

In such a circumstance …

… ALL of these currencies would be immediately ‘devalued’.

So what if we REVERSED the perspective.

What if we took the OPPOSITE ‘view’ ???

What if we suggest that a better solution than pushing Greece back into the Drachma … would be to let Germany resurrect the Deutsche Mark !!!

This would allow for some level of ‘rebalancing’ in the underlying macro-dynamic, particularly as it applies to trade.

Moreover, this would also allow for some ‘depreciation’ in the EUR linked to Spain, Italy, Portugal, Greece, France, et al … as one unit, relative to the German D-Mark.

Rather than ‘seeing’ the old Greek Drachma woman …

… we ‘see’ the younger German Deutsche Mark woman.

Fixed-income markets use the German Bund as the benchmark against which all other sovereign bond yields are measured, as the primary ‘credit spread’, so why not add the foreign exchange dynamic in the same way, using the D-Mark as a benchmark.

Indeed, the two tiered system is NOT ‘dead’ … but rather, the first tier would include ONLY ONE currency, the German currency.

It is Germany’s understandable obsession with hard-currency ‘driven’ monetary and fiscal policies, that ISOLATES THEM from the rest of the EU.

So, let them have their hard currency … the D-Mark.

And let the rest of the debt-offenders have the softer EUR.

Within the scope of enacting such a seemingly-outrageous idea, perhaps the legal framework can be ‘manipulated’ to enable the ECB to utilize freshly minted EUR, as a means to monetize, and thus ‘eradicate’, a portion of the region’s sovereign debt … in a move that would NOT need to be ‘approved’ by Germany.

Of course, EU officialdom is not likely to be at all enamored by this thought, but perhaps, maybe, potentially … plenty of support for such an idea could materialize.

For sure, there would be ‘problems’ and potential roadblocks that we have not yet contemplated. In fact, we generated this idea out of the blue, shooting from the hip on Thursday afternoon while doing an ‘interview’ with our buddy and colleague Jim Puplava, on his internet radio show “Financial Sense Newshour”(financialsense.com).

But I am, myself, personally … intrigued by the thought.

It seems to be worthy of debate, at least, given the ‘keystone-cop-routine’ (slapstick inefficiency) currently being performed by EU officialdom, as the crisis deepens, and broadens … daily.

And we mean … daily.

With nearly every data release, from any EU member nation, particularly those that are currently under the market’s microscope … the macro-economic crisis deepens, as does the push into outright deflation.

We need but evidence a mountain of data released in the EU within the last twenty-four hours, reports that include Spanish Retail Sales, Italian Unemployment, the comprehensive EU Commission Consumer and Business Sentiment Surveys, German CPI inflation, and the ECB’s money supply and bank credit figures, to quickly conclude that our thesis is VALID …

… the macro-deflation is deepening, and broadening in its scope.

Observe the chart below revealing the complete COLLAPSE in Spanish Retail Sales, as measured by the year-over-year rate-of-change, which plunged in April to a (-) 11.3% yr-yr pace of contraction (constant prices), a massive ‘deepening’ relative to March’s already negative (-) 4.0% rate of decline. Moreover, April’s rate of contraction is the second WORST EVER, behind only the Feb-2009 decline of (-) 11.8% yr-yr.

Also of interest within the chart, is the sequentially lower highs reached at each successive macro-cycle peak. The 2006 peak as below the 2003 peak, and the most recent cycle peak set in March of 2010 was lower than both of the previous peaks.

On a ‘Current Prices’ basis, Spanish Retail Sales fell by (-) 8.8% yr-yr, the worst performance in the last two decades.

And, we shine the spotlight on the two downside leaders, in terms of the sectors suffering the greatest degree of deflation in final retail demand —

— Personal Goods, which fell (-) 19.8% yr-yr

— Household Goods, which fell by (-) 14.3% yr-yr in April.

We also note this morning’s release of Italian Employment figures, revealing a decline of (-) 28,000 in the Number of Employed during April, marking the third monthly contraction in a row.

In fact, since the latest mini-crisis began in August of last year, the Number of People Employed in Italy has fallen in 7 out of 9 months, with 60% of the total job loss occurring in the last two months.

Indeed, in the last two months alone (Mar-April, May is MOST assuredly to be even worse) … Italy has lost the ‘US-equivalent’ of (-) 325,000 non-farm payroll employment, on a population-adjusted basis.

Subsequently, the Unemployment Rate rose to 10.2%, a greater than expected rise from the 9.8% rate originally reported for March, a figure that was revised to 10.1% with today’s report.

Telling is the increase from the swing-low reached in March of last year, at 7.9%, with the Unemployment Rate having soared by 2.3 percentage points, or by +30.0% nominally.

Supportive to our top-down macro-thematic thought-process is the intensifying pace of disinflation in EU Consumer Prices, particularly as it applies to Germany. Observing the chart on display below plotting the year-over-year rate of German CPI inflation. We focus on the decline to 1.9% in May, from 2.1% in April, thus bringing German inflation back below the ECB’s (allegedly) hard-cap (2%), and extending the retreat from the Sept-2011 high of 2.6% yr-yr. Moreover, Germany’s CPI inflation rate is now back below its 2-Year Moving Average.

More pointedly, we highlight past experiences since the nineties, during which German CPI inflation is receding, following a major-cycle peak above the ECB’s ‘upside band’. These time frames have been associated with intensified macro-market turbulence … on EVERY SINGLE OCCASION !!!!

From within this morning’s deluge of global macro-economic data, we extract the figures for the EU Manufacturing Purchasing Managers Index (PMIP), to spotlight the continued downside extension to a NEW MOVE LOW, as evidenced in the chart below.

Pegged at 45.1 for May, the Eurozone PMI has now been below the 2011 low for two consecutive months … and … has been below the boom-bust 50 level for TEN straight months.

Moreover, we note that the current level is the LOWEST since 2009 …

… and … we highlight the move by the secular-trend defining 2-Year Moving Average back BELOW FIFTY !!!

Always a monthly favorite is the EU Commission’s of extensively detailed Consumer and Business Sentiment Surveys. We start with the headline EU Business Climate Index, which, as seen in the chart below, plummeted during May to reach a new move low at (-) 0.77 … a level that in the past has been associated with ‘aggravated’ macro-market conditions.

Of particular interest is the decline in the secular-trend-defining 2-Year Moving Average, which has been trending lower since the middle of last year, and has now fallen below zero, again, a circumstance linked to expanded volatility in the markets, amid heightened deflation risk.

More ‘telling’, and thus troubling, is the macro-message to be extracted from an examination of the chart on display below in which we plot the ‘rolling’ back-to-back monthly change in the EU Business Climate Index.

The Index was down by (-) 0.26 in May, a deep single-month decline that came hard-on-the-heels of April’s monthly decline of (-) 0.24, for a back-to-back, ‘monthly’, cumulative decline of (-) 0.50 …

… which, puts the April-May 2012 period into the ‘danger-zone’, as defined within the chart, as the (-) 0.50 level. Indeed, previous periods where the headline EU Business Climate Index has fallen by this degree, are linked DIRECTLY to periods of ‘recession’, and heightened ‘crisis’ risk —

— in 1990-92, 1998, 2001, 2008-09 … and, now.

Another perspective is offered by the EU Commission, and their own, smoothed, “Twelve-Month Average Business Climate Index”. We note the non-stop, sequential-and-near-symmetrical collapse into negative territory, since last September:

May-12 … (-) 0.12

Apr-12 … + 0.03

Mar-12 … + 0.17

Feb-12 … + 0.31

Jan-12 … + 0.45

Dec-11 … + 0.58

Nov-11 … + 0.71

Oct-11 … + 0.82

Sep-11 … + 0.91

The EU Commission Surveys include detailed data for each EU-27 member nation, across the Service Sector, the Retail Sector, and the Construction Sector … with May readings being heavily skewed towards the negative, in every category, in nearly every country.

Having dissected all fifty-two pages, we come out with a common theme as it relates to the ‘country-performance’. To wit:

— Spain, Portugal and Italy are severely damaged, and sinking fast.

— the Netherlands, France, Belgium, Finland and Sweden are hurt, and the pain is worsening.

— Hungary is a potential wild-card.

— and, there is now sequential erosion in Germany.

Data scalpel in hand, we begin carving into the Service Sector readings, noting that the headline EU Confidence Index (services) fell to (-) 6.0 in May, down from (-) 3.7 in April … with the Future Demand Index falling to a barely positive + 0.4 in May, down from + 3.7 in April … and … the Recent Employment Index fell into negative territory for the second month in a row, pegged at (-) 1.9 in May, versus (-) 0.8 in April, and + 1.5 in March.

Of GREAT interest, particularly given the HIGH and RISING rates of Unemployment across the Continent … is the PLUNGE in the Service Sector Future Unemployment Index (expected). We evidence the chart on display below with focus on the recent mini-collapse back into negative ground.

The reading for May was pegged at (-) 3.1 … down from April’s (-) 0.4, and sharply lower relative to March’s positive reading of + 3.0. We also spotlight the previous violation of, and most recent downside reversal by, the long-term trend-defining 2-Year Moving Average.

We make several more detailed observations on the Service Sector data (all figures, for all sectors, are relative to April except where noted):

Spain, Recent Employment … (-) 21.1 … down from (-) 17.4

Spain, Future Employment … (-) 10.3 … sliding from (-) 1.7

France, Recent Demand … (-) 3.3 … down from + 2.5 (March)

Italy, Future Demand … (-) 9.2 … deepening from (-) 5.7 (March)

Italy, Confidence … (-) 19.5 … versus (-) 11.3 (March)

Netherlands, Confidence … (-) 10.3 … down from (-) 9.4

Belgium, Recent Demand … (-) 5.0 … down from + 4.3

Looking next at the Construction Sector, we observe that the headline EU Confidence Index dropped to a NEW MOVE LOW, at (-) 32.4, down from (-) 30.4 in April … with a particularly steep decline in the Construction Activity Trend Index, which plummeted to (-) 20.5 in May, from (-) 13.5 in April.

Breaking it down, we find the following data nuggets to be of interest:

Spain, New Orders … (-) 49.7 … ‘crashing’ from (-) 34.1

Spain, Confidence … (-) 56.6 … deeper still, from (-) 50.9

Portugal, Confidence … (-) 75.1 … down from (-) 66.1

Portugal, Employment … (-) 63.6 … down from (-) 51.1

Italy, Activity Trend … (-) 42.9 … down from (-) 39.0

Italy, Employment … (-) 18.6 … down from (-) 14.2

France, Confidence … (-) 16.4 … down from (-) 14.9

Hungary, Confidence … (-) 44.6 … down from (-) 43.0

Hungary, New Orders … (-) 64.7 … down from (-) 63.1

Netherlands, Employment … (-) 34.6 … plunging from (-) 26.1

And, of specific interest, is weakness in the ‘Nordics’, Sweden and Finland (Construction Sector indexes):

Finland, Confidence … (-) 19.3 … down from (-) 7.7 in April

Finland, Employment … (-) 20.3 … down from (-) 10.5 in April

Finland, New Orders … (-) 18.3 … down from (-) 5.0 in April

Sweden, Confidence … (-) 18.3 … down from (-) 2.9 in April

Sweden, New Orders … (-) 30.4 … down from (-) 14.9 in April

Sweden, Activity Trend … (-) 11.9 … down from + 6.4 in April

And of GREAT interest as it pertains to top-down confidence in the EU, from within, is the data on the Retail Sector. The headline EU Retail Sector Confidence Index slid to a NEW MOVE LOW, at (-) 14.6, falling from (-) 8.5 in April. Moreover, EVERY index fell, except, unfortunately, Inventories, which increased on the back of diminished demand.

We specifically spotlight the decline in the Business Index, which fell to (-) 19.7 in April down from (-) 8.6 in April, along with the slide in Future Orders, which fell to (-) 14.8, from (-) 9.9. And, we note a second straight monthly decline in the EU Retail Employment Index. Carving into the country data, we feature the following points-of-interest, as the EU Retail sector comes under increasingly acute, and broad-based downside pressure:

Spain, Business … (-) 23.5 … down from (-) 10.3

France, Future Business … (-) 12.3 … down from (-) 2.8

France, Confidence … (-) 20.3 … down from (-) 9.4 in April

France, New Orders … (-) 18.1 … down from (-) 12.5

Belgium, Confidence … (-) 16.4 … down from (-) 12.0

Belgium, Future Business … (-) 23.2 … down from (-) 17.9

Italy, Business … (-) 51.6 … down from (-) 38.0

Italy, New Orders … (-) 35.4 … down from (-) 30.9

Portugal, Business … (-) 48.7 … down from (-) 46.2

Hungary, Business … (-) 10.4 … down from (-) 1.9

Hungary, New Orders … (-) 15.5 … down from (-) 9.5

Austria, Confidence … (-) 11.0 … down from (-) 2.0

Lithuania, Confidence … (-) 12.3 … down from + 4.8

And, even in Germany, there is more than just ‘erosion-in-growth’ going on, with an outright CONTRACTION unfolding in the German Retail sector, in synch, timing wise, with the first rise in the Number of Unemployed since 2009, posted last month.

Note the darkening skies over Germany’s retailers:

Germany, Confidence … (-) 13.6 … down from (-) 3.9

Germany, Business … (-) 1.9 … down from + 16.7

Germany, New Orders … (-) 8.7 … down from (-) 0.8

Germany, Employment … (-) 2.7 … down from + 0.3

The broadening and deepening COLLAPSE in ‘confidence’ among both business leaders, and consumers … only serves to exacerbate the bigger-picture risk defined by the potential for a region-wide run on bank deposits. We examined the data in last week’s “Smell and Tell” Monitor, and we got updated figures on Wednesday (for the month of April) from the European Central Bank detailing money supply and bank balance sheet figures.

Disturbing for sure, is the fact that the largest component of EU Bank Deposits, Overnight Deposits, deflated in April, and is perilously close to a rare downside violation of the 12-Month Average. See the chart below.

GLARING is the message gleaned from the chart below, in which we plot the month-to-month change in Overnight Bank Deposits … revealing that April’s ‘run’ (ooops, I mean decline) of (-) 55.8 billion EUR, is the largest single-month contraction in at least the fifteen years.

We cannot help but wonder, in the context of today’s top-down theme (a return of the German Mark, instead of the Greek Drachma), might such a move offer some sense of ‘confidence’ in cementing the belief that the Drachma is NOT coming back, and thus the Peseta, Lira and Franc are not likely to return either ??? … particularly if removing the German political roadblock allowed the ECB to load up with debt monetization firepower !!!

Maybe, and maybe not. Perhaps there would just be a rush out of the watered-down EUR, and into DEM, sparking yet another type of ‘crisis’. Unfortunately for all involved, non-action is a KILLER, and this dynamic, as it specifically applies to the ECB, is evidenced by the fact that, thanks largely, though not solely to the historic decline in Overnight Deposits, the three key money supply aggregates, narrow M-1, M-2, and broad M-3 … ALL … posted outright contractions in April.

Indeed, broad money M-3 contracted by (-) 51 billion EUR during the month, which drove the year-over-year rate-of-change sharply lower, to +2.5% in April, down from +3.1% in March. Evidence the chart below revealing that the April reversal may mark a post-crisis peak in money growth, particularly if Bank Deposits continue to decline (which they most certainly did, in May).

We also focus on the continued push towards intensified deflation in bank lending, with a MASSIVE (-) 49 billion EUR single-month contraction in Loans to Other (private sector) Euro-Area Residents … with broad based declines in a variety of loan ‘types’, including Consumer Credit. Consumer Credit fell by (-) 2.0 billion EUR in April, and the year-year rate dumped deeper into overtly negative territory, at (-) 2.4%, down from (-) 2.1% yr-yr in March, and down from (-) 1.9% yr-yr in February. We note the charts below (ECB).

The most important signal offered today by the markets …

… was that flashed by the German stock market, as per the massive decline in, and technical breakdown by, the DAX.

Evidence the daily chart on display below plotting the nearby continuous DEX futures contract since the 1Q of 2010. We focus on the most recent downside violation of the uptrend line in place since last fall’s low … a move that came in synch with the plunge into outright bearish territory by our med-term Oscillator.

Moreover, we also focus on the negative evolution in the moving average alignment, as the short-term 50-Day EXP-MA crosses below the med-term 100-Day EXP-MA … and all three, including the long-term 200-Day EXP-MA have completed their own downside reversals, directionally speaking.

The DAX is … ‘exposed’ … as evidenced in the long-term weekly overlay chart below in which we compare the percentage returns generated by various key EU stock indexes, since the end of 2004. We note that Germany is MOST CLOSELY linked to Spain, and thus the breakdown in Spain is likely more than the DAX can withstand, without cracking wide open itself.

Lest we forget the cold hard fact … Germany is itself, in VIOLATION of the Union Treaty rules as it applies to their sovereign-debt-to-GDP ratio.

Amid today’s violent breakdown in the German DAX, we flash the spotlight on the chart below plotting the 5-Year Sovereign Credit Default Swap linked to Germany’s government debt, which totals more than 1.1 trillion EUR.

Simply, Germany’s CDS is breaking out to the ‘upside’, indicating that investor anxiety about a possible DEFAULT on Bunds, BOBLs, and Schatze, is on the rise, as defined by the violation of the downtrend line, and the move back above 100 basis points.

Of course we must take note of this week’s move in, and today’s close by, the Spanish 5-Year Sovereign Credit Default Swap, which, again, did NOT benefit from chatter related to ECB restarting their asset purchase program, and buying Spanish government debt outright (as Spain would like).

Clearly, the breakout to a NEW ALL-TIME HIGH in the Spanish CDS is NOT a positive sign, and exemplifies the intensified risk of having EU officialdom debating, rather than doing.

The Spanish 5-Year Sovereign Bond yield is probing its crisis high close of 6.29%, and has held above our danger-trigger of 5.50%.

Evidence the chart below, with focus not only on the most recent renewed upside explosion in yield, but also the bearish (higher yield) realignment by the two key med-long-term moving averages, as the med-term 100-Day EXP-MA rises above the long-term 200-Day EXP-MA, while both averages are accelerating to the upside, velocity wise.

Clearly, a move above 6.30% would set off alarm bells.

In the next couple of weeks we will be closely monitoring the German DAX, the Spanish 5-Year Bond yield … among many things … and, we will be specifically focusing on two instruments in particular, the Credit Default Swaps linked to Italian and French government debt.

First, we look at the 5-Year Italian CDS, seen in the chart below. We note the most recent upside spike, and the renewed directional uptrend in the long-term trend-defining 200-Day EXP-MA.

Clearly, a move above 600 basis points would set off alarm bells.

Similarly, a move above 250 basis points in the French 5-Year Sovereign Credit Default Swap, would set off alarm bells. See the chart below.

Given the recent verbal assault on German leaders, by French, Spanish, and Italian leaders … might we being to discuss a ‘coup’ ???

Could it be, that Europe decides to kick Germany out, instead of Greece ???

Okay, maybe it is not that ‘dramatic’, maybe Germany ‘opts out’ of the Eurocurrency, like the UK, or Sweden, and brings back the Deutsche Mark, as a way to maintain their own hard-currency policies, while ‘freeing-up’ the rest of Europe, to pursue debt monetization, and debasement of the new, softer, EUR (ex-Germany). At the very least it would give Germany a choice … remove your objection to a softer EUR … or go your own way.

Food for thought.

In the meantime, we remain bearish on European stock indexes, along with the US S+P 500 and German DAX. We continue to focus on the Spanish IBEX, the Euro STOXX-50, the ‘Dutch’ AEX, the UK FTSE, and the Italian MIB.

We also remain bullish on the US Dollar, with concurrent bearish focus on the Eurocurrency, the Swedish Krona, the British Pound, the Indian Rupee, the Korean Won, the Brazilian Real, the Chilean Peso, the Mexican Peso, the African Rand, and the New Zealand-Australian-and-Canadian Dollars.

We remain bullish on the US and Australian 10-Year Bonds … and bearish on the Italian 10-Year BTP Bonds.

As for Gold and Silver, recall that we stated on Wednesday …

“We remain bearish on Gold and Silver, though we are cognizant of the potential for a major low to be ‘established’ at any time, on the basis of an intensifying debt crisis in the EU, and the possibility of an overt debasement of the EUR.

For sure, we note the triple-bottom pattern in both Gold and Silver, a pattern which has turned into a quadruple-bottom with today’s upside reversal from $1532 in August Gold futures … and … a pattern defined by the higher low set in Silver. We are tightening our stops.”

We are out, and now neutral on Gold and Silver, as things played out today, EXACTLY as we suggested they might.

We remain bearish on Industrial Metals, with focus on Copper, Aluminum, Nickel, Tin, Platinum and Palladium.

And, we remain bearish on select commodities, with focus on Sugar, Cocoa, Cotton, Corn, and Orange Juice.”

Gregory T. Weldon