German Court Clears Way for ESM Fund

There is no stopping the coming inflationism as German’s top constitutional court threw out of the window the legal opposition to the ESM rescue mechanism

From Bloomberg.com

Germany’s top constitutional court cleared the way for the permanent euro-area rescue fund, rejecting bids to halt German ratification of the 500 billion- euro ($644 billion) backstop while imposing some conditions on its use.

The Federal Constitutional Court in Karlsruhe today dismissed motions filed by groups including a conservative lawmaker and an opposition political party that sought to block the fund, known as the European Stability Mechanism, and a deficit-control treaty championed by Chancellor Angela Merkel. The court stipulated that a cap of about 190 billion euros be set on German liabilities before ESM ratification, unless parliament decides to back extra funds.

“The review has concluded that the laws that were challenged, with high probability, do not violate the constitution,” chief justice Andreas Vosskuhle told the court. “Hence the motions for a temporary injunction were to be rejected.”

The legal challenge to the planned rescue fund highlights bailout fatigue in Europe’s largest economy and delayed efforts by Merkel and other euro-area policy makers to stem the region’s debt crisis. In the neighboring Netherlands, Prime Minister Mark Rutte, a Merkel ally, is seeking re-election today…

“Some uncertainties” about the limit on Germany’s contribution to the ESM and the scope of the German parliament’s say over the fund also flowed into the ruling, Vosskuhle said. The judges also said that Germany must state when ratifying that it won’t be felt bound by the treaty unless these reservations are efficiently met.

Today’s cases were filed after German lawmakers approved the ESM and the fiscal pact, a deficit-control treaty designed to impose budget discipline on European Union member states. About 37,000 people signed up to endorse a constitutional complaint filed by political group “Mehr Demokratie e.V.” Other plaintiffs include opposition party Die Linke as well as Peter Gauweiler, a lawmaker from Merkel’s CSU Bavarian sister party.

Perhaps the Fed's Ben Bernanke and the FOMC will make the next move.

ECB-China Stimulus: Has the Risk ON Environment Returned?

Here is what I wrote last week[1],

Mounting expectations and deepening dependence from central banking opiate, which has been clashing with the unfolding economic reality, will prompt for more price volatility on both directions. The Bank of America posits that QE 3.0 has been substantially priced in.

Eventually stock markets will either reflect on economic reality or that central bankers will have to relent to the market’s expectations. Otherwise fat tail risks may also become a harsh reality.

The ECB and China’s government eventually relented to the market’s expectations

“Unlimited government bond buying” bazooka program[2] launched by the European Central Bank (ECB), last Thursday, spurred one of the best one-day rally for many global stock markets for the year.

China also announced of a modest infrastructure spending stimulus to the tune of the 1 trillion yuan or US 157 billion[3] last Friday. China’s rescue program seems to have been timed or coordinated with the ECB’s action.

China’s package looks “modest” because the earmarked amount for fiscal spending projects accounts for only a little over a quarter of the $586 billion stimulus implemented in 2008-2009.

Nonetheless the combined stimulus by the ECB and China nudged an astounding reprisal by the browbeaten bulls: the Shanghai index soared by 3.7% on Friday!

The steroid boosted activities of China’s Shanghai index exhibited the same theme for most of the major equity benchmarks for the week.

The weekly advances concealed the real activities.

Much of the global equity markets were marginally changed when both announcements provoked end of the week spikes. Only Malaysia among the majors lost ground.

Deepening Gulf Between Market Prices and Economic Events

This week’s remarkable rally reveals of two important insights.

ONE. Financial market has been responding to interventions rather than to actions in the real world.

Increasing detachment has characterized the actions in the financial markets relative to real economic activities.

Industrial production in the Eurozone[4] (see left window) have generally been cascading throughout 2012, however European stocks, particularly the German DAX, French CAC, and Italy’s iShares MSCI and Spain’s IBEX has been ascendant since May (see right window).

Year to date, the DAX has been an up by an outstanding 22.31%, the CAC 40 11.37% and Italy’s iShares MSCI 6%. Spain’s Ibex has trimmed losses to only 8%.

Economic performance and stock prices have been going in opposite directions.

Well this has not been limited to the Eurozone.

Divergences can be seen from accounts of declining GDP or economic growth for the G-7, the Eurozone and the US, although the OECD projects that America may defy the global momentum for the rest of the year.

The OECD projection according to the Economist[5],

The global economy has weakened since the spring and the OECD predicts that in the next quarter the GDP of the G7 group of richest countries will grow by just 0.3% (at an annual rate), down from an already anaemic 0.9% in the second quarter. America provides a rare bright spot, but the three biggest economies in the euro zone, Germany, France and Italy, are set to shrink by 1% in Q3, worse even than their 0.3% contraction in Q2. Indeed, figures released on the same day by Eurostat show that GDP growth in the 17 euro-zone countries fell from zero in the first quarter to -0.2% in the second, and from zero to -0.1% in the 27-country European Union.

I don’t share the OECD’s sanguine expectations on the US. The US will, like her global contemporaries, be hobbled by contagion linkages, political bickering and an internal slowdown.

Come to think of it, the OECD expects Germany to fall into a recession by the end of the year[6]. But the German equity benchmark, the DAX, seems to negate all the troubles ahead and seems approaching April 2011 highs. One of them is wrong, so which is which?

In addition, global trade (light blue line, lower window from the Economist chart) has been drifting in conjunction with global manufacturing activities (Purchasing manager’s index based on new export orders, dark orange line) to the downside. Yet except for the Shanghai index which has been slightly down, aside from Japan’s Nikkei and Malaysia’s KLCI, which has lagged, all other major indices have posted superior double digit year to date returns.

Importantly, the deterioration in global trade and global manufacturing activities has not just been a decline in the trend of growth, instead current data suggests that both indicators have exhibited signs of contraction. About 80% of global manufacturing activities have reportedly been in contraction[7].

So once again stock markets live in a different reality from the economic picture.

We go next to US corporate profits.

Corporate profits seem to have also diverged from the upside price momentum of US major equity prices.

Based on the following profit measures, 1) S&P 500 Earnings Per Share, 2) After-Tax Net Income 3) Pre-Tax Profits by Source, 4) Financial Corporate Profits and 5) Profits from Abroad, Dr Ed Yardeni chief of prominent research firm Yardeni Research, weighs on the profit segment based on an empirical analysis and makes the following conclusions.

In enumerated order, Dr Yardeni[8] says that profits has 1) “lost its upward momentum”, 2) have been “running out of steam”, 3) “have stalled in a zigzag fashion”, 4) “looking especially toppy” and 5) “weakest growth rate since Q3-2009” which implies of “a decline twice as much for overseas profits”.

Mr. Yardeni’s seemingly drab undertone comes prior to Thursday’s ECB-China fueled boom. The point here is that sustained upside price increases for US stocks will push valuations into overpriced territory.

Domestic data hasn’t been that promising too.

Last week’s US jobs data came worse than expected but apparently have been either ignored by the US markets because ECB’s action may have drowned out such negative news or could have been interpreted as the du jour “bad news is good news”.

The job data on the surface showed mediocre signs of improvement. But this came amidst a decline in the labor force. The labor force participation rate (63.5%) dropped to lowest level since May 1979, according to Northern Trust[9] (left window).

Compounding on this, notes the Wall Street Journal Blog[10], is that for June there had been fewer jobs created, manufacturing shed 15,000 jobs which essentially reflected on the ongoing downturn, and fewer people are working.

Many talking heads see this unimpressive and lacklustre economic performance as rationalization for the FED to pursue further easing measures during their FOMC meeting by next week.

From a fundamental standpoint, surging US markets suggest either that 1) moves by central banks (particularly the ECB which will likely be complimented by the FED for political reasons*) will dramatically reverse the dynamics of all of the above concerns, in order for the global equity markets to justify on their current price levels, or 2) the price-fundamental disconnect will only amplify risks for a violent “reversion to the mean”.

* as stated last week, Mr. Bernanke will seek to retain his tenure by propping up the markets to support President Obama’s re-election

The great disconnect is in reality signs of contortions from inflationism.

As the great American economist, philosopher and journalist Henry Hazlitt once wrote[11]

Because inflation leads inevitably to distortions in the interest rate, because during it nobody knows what future prices, costs, or price-cost relations are likely to be, it inevitably distorts and unbalances the structure of production. It gives rise to multitudinous illusions. Because the nominal interest rate, though it rises, does not rise enough, funds are more heavily borrowed than before; uneconomic ventures are encouraged; corporations making high nominal profits invest abnormal sums in expansion of plant. Many regard this, when it is happening, as a happy byproduct of inflation. But when the inflation is over much of this investment is found to have been misdirected—to have been malinvestment, sheer waste. And when the inflation is over, also, there is found to be, because of this previous misdirection of investment, a real and sometimes intense capital shortage.

The second implication from the current rally is that whatever one has conventionally learned from investing has been rendered irrelevant, if not obsolete, by sustained manipulation of prices of financial markets for political reasons.

That political reason has been to effect price controls in the financial markets by burning shorts in order to save the current political order.

Fund manager and Credit Bubble Bulletin (CBB) analyst Doug Noland is spot on with the dynamics behind the current developments[12]

With the financial world fixated on Draghi, Bernanke and endless QE, global markets now wildly diverge from economic fundamentals. Many are content to celebrate, holding firm to the view that financial conditions tend to lead economic activity. Markets discount the future, of course. And, traditionally, an easing of monetary policy would loosen Credit and financial conditions - spurring lending, spending, investing and stronger economic activity.

Importantly, traditional rules and analysis no longer apply. Monetary policy has been locked in super ultra-loose mode now entering an unprecedented fifth year.

This serves as further proof that earnings, economic growth or chart patterns have become subordinate to the actions of central bankers and government authorities in determining stock price movements

ECB’s Actions Enhances Stagflation Risks, Bernanke Next?

Part of the newly announced ECB program includes the replacement of Securities Markets Programme (SMP) with new Outright Monetary Transactions programme (OMT) which is conditional to the EFSF/ESM facility, the ECB also removed the senior status on its purchases and importantly “the easing of collateral rules, namely suspension of the minimum rating threshold for countries with an OMT or an EU-IMF programme. Thus, government bonds (and government guaranteed bonds) no longer face the risk of not becoming eligible collateral (unless countries do not deliver on reforms of course). This should remove an important risk for banks buying government bonds” according to Danske Research[13].

Optimism derived from the tinkering with so called self-made regulations shares the same myopic political idea that edicts have the power to eliminate risks and overpower economic reality.

There are many aspects to deal with covering the ECB’s latest announcement.

These include among the many

-the willingness of crisis stricken nations to sacrifice their sovereignty to the supervising troika (EU, ECB and the IMF) by applying for the EFSF/ESM facility in order for the ECB mechanism to be triggered,

-the political support from the average Germans for the sustained wealth transfer mechanism to the PIGS. Germany’s Constitutional Court will decide on the ESM court case by next week amidst political street protests[14] and

-if these measures will ever work at all.

I think what really matters now will be undeclared objectives by the ECB for such measures. Despite the conditionality to allegedly “sterilize” such interventions, the ECB will have limited means to do so.

First, the ECB will have to sell assets to offset its direct bond purchases. Indirect purchases can also be made through the commercial banking system financed by the ECB.

This means that for the ECB to conduct sterilization, only non-crisis tainted (PIIGS) assets presently held or owned by the ECB will be available for sale, or that the ECB has to shrink its loans to banks collateralized by non-PIGS bonds[15]

Since non PIIGS assets are limited, once used up, the ECB will likely be engaged in unsterilized actions.

Next, if these will be sterilized by fixed term deposits or weekly deposit tenders[16], which function as another form of reserves, the build up of reserves at the ECB will only amplify the debt pyramiding dynamic of the cartelized tripartite political system comprising the banking system, central bank and the government/welfare state through cross financing (banks finance government, the government capitalizes and provides monopoly legal tender status to central banks, central banks backstops the banks and provides financing indirectly to governments through banks (bond buying).

By having to artificially reduce interest rates, governments of the PIIGS will likely defer on making the required reforms and continue with their spending binges, thus, exacerbating the current conditions.

Importantly, the easing of collateral rules may have opened the floodgates for the feedback loop of mechanism of massive debt issuance and ECB buybacks since “banks under the programme”, according to Austrian economist Bob Wenzel who quotes another expert [17], will be able “to use the self-issued government guaranteed debt as collateral”

The point is that the recent price action of commodities seems to have “seen through” the legerdemain over so-called “sterilization”, and have moved significantly up nearly across the board. Such actions appear to be signaling the resurgence of an inflationary boom.

Gold will probably test the 1,800 level by the yearend, oil (WTIC), copper and the broad based commodity benchmark the Reuters CRB (CCI) index have turned materially to the upside.

I hardly believe that this will be the same prolonged Risk ON environment as before. With unlimited or open ended options (US Federal Reserve has already been taking this in consideration), central bankers have been increasingly signaling urgency and desperation.

Yet there are very important differences from today’s implementation of easing programs compared to the past: interventions are being done amidst elevated commodity price levels.

And if commodity price inflation will spillover to the real economy, such euphoria will likely be short term. This will likely be seen first in emerging markets such as the Philippines.

Current environment, for me, seems like very fragile and precarious.

Stocks Under a Stagflationary Environment

As I pointed out in the past, imposing inflationary measures under the current environment heightens the risks of stagflation.

Signs of stagflation have also been transmitted not only to gains in commodity prices but also on global mining stocks.

I would further add that if the US Federal Reserve joins the ECB next week, then the current short term RISK ON momentum may persist, but advances will likely be skewed towards commodities.

Eventually I expect a structural departure between mining and resource with the general trend once the stagflation dynamic becomes entrenched.

Resource companies have the potential to surf the stagflation tide, while others will be restrained by consumer price controls, realignment of economic activities towards consumer staples and higher input costs that will crimp on profits.

Mr. Hazlitt on why the stock market in general faces downside risks during high inflation-stagflation regimes[18].

The causes of these disappointing results have been somewhat complex. Let us recall once more that in any inflation, individual prices and costs never go up at a uniform rate but at widely different relative rates and times. Cost-price relationships become discoordinated. Individual firms find it increasingly difficult to know or guess what their own future costs or future selling prices are going to be, and what will be the ratio between them. During an inflation demand shifts quickly from one product to another. This makes it increasingly difficult to plan production ahead, or to estimate future profit margins. In the later stages of an inflation, wage rates are more certain to go up than individual prices. Even if aggregate profits increase in monetary terms, the range of deviation and dispersion is much greater as between different firms. The investor faces increasing uncertainty. This always tends to lower stock prices.

Because the future of the business is increasingly uncertain, corporations become more reluctant to pay out dividends. If, as in many cases, profits are particularly high in money terms, if inventories and plant and equipment are constantly rising in price, more and more plant managers conclude that the best use of their current profits is to plow them back immediately into expansion of the business. This seems especially the most profitable thing to do in a hyperinflation. It then seems foolish to declare dividends when, by the time the stockholders receive them, they may be worth much less than they were when declared

Bottom line: Bubbles: Illusions of Progress

Financial markets have become materially detached from the unfolding real events. Markets are suggesting not only of recovery, but of a strong upside momentum in terms of economic recovery, whereas present global economic trends have been increasingly portentous of the risks of a global recession. If current diametric positions will remain, such growing divergences may accelerate a buildup on the risks of sharp downside volatility.

Such distortions seem to have become embedded into the market’s psyche. An upside market has now become an entitlement as impressed upon to the public through inflationist policies.

Yet current policies as noted above have been rewarding the bulls while punishing the bears (particularly the shorts). Policies have been designed to wrench economic reality with hope (some call it “hopium” or concatenation of hope and opium or addictive hope) that inflationism will work even if history has shown that it hasn’t.

And not only has such inflationist policies been promoting the “orgy of speculation”, this has been intensely obscuring price signals and economic coordination while giving the public illusion of progress.

As a side note, I recall last week when I presented signs of “portfolio pumping” in the domestic stock exchange, I read a remark somewhere that there should be a congressional investigation on this. Oh puhleez (to borrow Mr. Bob Wenzel’s expression), spare the market from further politicization. It has been bad enough that markets are already being directly and indirectly manipulated and assaulted for political reasons through various policies hardly understood public.

By adding more political interferences, eventually we all get what we deserve real hard.

---

[1] See Phisix: Why The Correction Cycle Is Not Over Yet September 2, 2012

[2] See ECB’s Mario Draghi Unleashes “Unlimited Bond Buying” Bazooka, Fed’s Ben Bernanke Next? September 7, 2012

[3] See China Joins Stimulus Bandwagon via Massive Infrastructure Spending September 7, 2012

[4] Weekly Focus ECB back as fire fighter and it works, Danske Research, September 7, 2012

[5] Graphic Detail The European effect Economist.com Blog September 6, 2012

[6] Speigel Online OECD Predicts Recession for Largest EU Economy September 6, 2012

[7] See 80% of World Manufacturing Activities Contracting, September 4, 2012

[8] Ed Yardeni Profits Dr. Ed’s Blog September 4, 2012

[9] Asha Bangalore August Employment Data Contain Ample Evidence to Justify QE3, Northern Trust, September 7, 2012

[10] Wall Street Journal Blog Five Key Takeaways From Jobs Report September 7, 2012

[11] Henry Hazlitt The Inflation Crisis, And How To Resolve It, p.125 Mises.org

[12] Doug Noland Diverging Like It's 1929, September 7, 2012 Credit Bubble Bulletin Prudent Bear.com

[13] Danske Research ECB meeting: ECB is now waiting for Spain, September 6, 2012

[14] Reuters.com Hundreds of Germans protest against euro rescue steps September 8, 2012

[15] Lawrence H. White How much dodgy debt will the ECB buy?, September 7, 2012 Freebanking.org

[16] The Tell, Euro gets boost from ECB sterilization speculation Marketwatch.com September 6, 2012

[17] Robert Wenzel The Magic Tricks of Mario Draghi Economic Policy Journal September 8, 2012

[18] Henry Hazlitt op cit p.146

ECB’s Mario Draghi Unleashes “Unlimited Bond Buying” Bazooka, Fed’s Ben Bernanke Next?

So finally, the ECB via president Mario Draghi unleashed what seems as the penultimate “shock and awe” rescue mechanism for the EU: the supposed “unlimited but sterilized” buying of bonds.

From Bloomberg, (bold added)

European Central Bank President Mario Draghi said policy makers agreed to an unlimited bond- purchase program to regain control of interest rates in the euro area and fight speculation of a currency breakup.

The program “will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro,” Draghi said at a press conference in Frankfurt after the ECB held its benchmark rate at a record low of 0.75 percent. “Under appropriate conditions, we will have a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area.”

Draghi has staked his credibility on the bond plan, which is the most ambitious yet in the central bank’s fight to wrest back control of rates in a fragmented economy and save the euro after nearly three years of turmoil. Now it’s up to governments in Spain and Italy to trigger ECB bond purchases by requesting aid from Europe’s rescue fund and signing up to conditions

“Governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial-market circumstances and risks to financial stability exist -- with strict and effective conditionality,” Draghi said. The ECB reserves the right to terminate bond purchases if governments don’t fulfil their part of the bargain, he added…

The ECB’s program, called Outright Monetary Transactions, will target government bonds with maturities of one to three years, including longer-dated debt that has a residual maturity of that length, Draghi said. Purchases will be fully sterilized, meaning that the overall impact on the money supply will be neutral, and the ECB will not have seniority, he said.

Note that ECB bond purchases have not truly been “unlimited” as they supposedly conditional to the requested “aid” by crisis stricken nations from the ESM and will be “fully” sterilized. Aside from conditionality on reforms.

As usual political terminologies matter.

The idea of full sterilization means that money will be drained from the other sectors and will allegedly be neutral. This could be the reason behind the underperformance and the tepid gains of gold and other commodities as oil and copper despite the ECB's opening of the inflation spigot.

Moreover, perhaps too, the ECB assumes that need for bond buying may be checked or will have the desired effect of providing carrot and stick approach for governments to take appropriate corrective fiscal measures.

Unfortunately this won’t likely be the case.

Not only is the bond buying going to be an incentive for delaying the necessary reforms for the PIGS (out of moral hazard dilemma), but the ECB’s sterilization activities will likely be also restricted.

University of Chicago Professor John Cochrane at the Bloomberg explains…...

If past were to rhyme, in November of last year, the ECB has missed sterilizing her purchases.

So if the ECBs action to sterilize are encumbered, then this means either that the ECBs buying will have short run effects, or that designated conditions represents smoke and mirrors which may pave way for the massive unsterilized actions or monetary inflation.

Nonetheless, I think the ECB’s unlimited option has been coordinated with the US Federal Reserve.

Just a few days back, four Federal Reserve presidents discussed of the same open-ended buying option.

From another Bloomberg article,

Federal Reserve Chairman Ben S. Bernanke says the U.S. economy is “far from satisfactory.” His colleagues are moving to embrace policies that will stay in place until he’s satisfied.

Four Fed presidents have come out in favor of an open-ended strategy for bond buying, with three calling for the program to begin now. Rather than specify a fixed amount of bonds to purchase by a certain date, such a strategy would leave the Fed able to announce a pace of purchases that it could adjust as the economy gets closer to Bernanke’s goals.

“You would be able to react to the incoming data in an incremental way and not be in a situation where you have to either drop the bomb or do nothing,” St. Louis Fed President James Bullard said in an interview last week during the Fed’s annual monetary policy symposium in Jackson Hole, Wyoming.

Bernanke used the forum to defend unorthodox policies such as bond purchases and made the case for further action to reduce an unemployment rate that he called a “grave concern.” Stocks and Treasuries jumped after the speech as investors increased bets the Fed will opt for further easing as soon as its next meeting Sept. 12-13.

I am inclined to the view that the FED will move to compliment the ECB for political reasons. I think that Bernanke’s tenure depends on President Obama’s re-election and thus would work to ensure of policies that will be “stock market friendly”

And as I previously said, the combined actions by central banks will eventually lead to deepening stagflation manifested through high consumer prices and the real risks of a food crisis that amplifies risks of social instability, as well as, overseas bubbles.

Central bank fixes has only short term narcotic effects, that risks long term unintended consequences.

As the great Professor Ludwig von Mises presciently warned,

But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a “crack-up boom” and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis. The depression follows in both instances.

For now, the risk ON “orgy of speculation” environment may have been activated based on a partial fulfilment of market’s addiction for central bank steroids.

But given the vagueness of conditionalities from the ECB program and of the response by other central bankers to real economic events, the sustainability of such risk ON conditions remains unclear.

We are approaching the Mises moment.

Spain’s Capital Flight Intensifies

In Spain, political solutions have been prompting for a deepening crisis.

From the New York Times,

“The macro situation in Spain is getting worse and worse,” Mr. Vildosola, 38, said last week just hours before boarding a plane to London with his wife and two small children. “There is just too much risk. Spain is going to be next after Greece, and I just don’t want to end up holding devalued pesetas.”

Mr. Vildosola is among many who worry that Spain’s economic tailspin could eventually force the country’s withdrawal from the euro and a return to its former currency, the peseta. That dire outcome is still considered a long shot, even if Spain might eventually require a Greek-style bailout. But there is no doubt that many of those in a position to do so are taking their money — and in some cases themselves — out of Spain.

In July, Spaniards withdrew a record 75 billion euros, or $94 billion, from their banks — an amount equal to 7 percent of the country’s overall economic output — as doubts grew about the durability of Spain’s financial system.

The deposit outflow in Spain reflects a broader capital flight problem that is by far the most serious in the euro zone. According to a recent research note from Nomura, capital departing the country equaled a startling 50 percent of gross domestic product over the past three months — driven largely by foreigners unloading stocks and bonds but also by Spaniards transferring their savings to foreign banks.

The withdrawals accelerated a trend that began in the middle of last year, and came despite a European commitment to pump up to 100 billion euros into the Spanish banking system. Analysts will be watching to see whether the August data, when available, shows an even faster rate of capital flight.

More disturbing for Spain is that the flight is starting to include members of its educated and entrepreneurial elite who are fed up with the lack of job opportunities in a country where the unemployment rate touches 25 percent.

According to official statistics, 30,000 Spaniards registered to work in Britain in the last year, and analysts say that this figure would be many multiples higher if workers without documents were counted. That is a 25 percent increase from a year earlier.

“No doubt there is a little bit of panic,” said José García Montalvo, an economist at Pompeu Fabra University in Barcelona. “The wealthy people have already taken their money out. Now it’s the professionals and midrange people who are moving their money to Germany and London. The mood is very, very bad.”

It is possible that the outlook could improve if the European Central Bank’s governing council, which meets Thursday, signals a plan to help shore up the finances of Spain and other euro zone laggards by intervening in the bond markets.

Spain’s capital flight dilemma has mainly been symptoms from fears of devaluation (or rampant inflationism) from the possible reinstitution of the peseta. Such actions to preserve savings flies in the face of those who argue for the devaluation snake oil fixes.

And where “members of its educated and entrepreneurial elite” shifts money out of the system, Spain’s economic recovery will remain dim as productive capital seek refuge or allocate savings elsewhere.

Moreover, the political solution of perpetual bailouts [“plan to help shore up the finances of Spain and other euro zone laggards by intervening in the bond markets”], accounts for as doing the same thing over and over and expecting different results, have only been intensifying the predicament

Yet the above account represents as another sign where ground economic activities have been moving in the opposite direction relative to the actions of financial markets.

Eventually reality will be priced in.

Eurozone’s Nascent Signs of Stagflation

Stagflation according to Wikipedia.org is a situation in which the inflation rate is high, the economic growth rate slows down, and unemployment remains steadily high

This Bloomberg article entitled Euro-Area Unemployment At Record, Inflation Quickens: Economy suggests that the Eurozone is now suffering from stagflation.

Euro-area unemployment rose to a record and inflation quickened more than economists forecast as rising energy costs threaten to deepen the economic slump.

The jobless rate in the economy of the 17 nations using the euro was 11.3 percent in July, the same as in June after that month’s figure was revised higher, the European Union’s statistics office in Luxembourg said today. That’s the highest since the data series started in 1995. Inflation accelerated to 2.6 percent in August from 2.4 percent in the prior month, an initial estimate showed in a separate report. That’s faster than the 2.5 percent median forecast of 31 economists in a Bloomberg survey.

A 12.4 percent surge in crude-oil prices over the past two months is leaving consumers and companies with less money to spend just as governments seek ways to contain the debt crisis. European economic confidence dropped more than economists forecast to a three-year low in August and German unemployment increased for a fifth month, adding to signs the euro-area economy continued to shrink in the third quarter.

“The whole euro zone is undergoing negative growth developments,” Don Smith, a London-based economist at ICAP Plc, told Ken Prewitt on Bloomberg Radio yesterday. “The sense is that increasingly the euro-zone crisis is bearing down on countries in northern Europe and Germany in particular and this is really forcing officials’ hands toward coming up with a firm solution.”

Europe’s nascent stagflation in pictures,

All three elements of stagflation, namely, elevated CPI or price inflation, contracting economic growth and high unemployment rates appear to be intact. (chart from trading economics)

And the so-called “firm solution” for policymakers translates to even more inflationism by the European Central Bank (ECB).

From the same article…

The ECB, which in July cut its benchmark interest rate to a record low of 0.75 percent, is working out details of a plan to purchase government bonds of distressed nations along with Europe’s rescue fund. So far, neither Italy nor Spain has asked for help from the bailout facility, the European Stability Mechanism.

The central bank, led by Mario Draghi, will hold its next meeting on Sept. 6 in Frankfurt.

“There may be a little bit of disappointment,” Piero Ghezzi, head of global economics at Barclays Plc, told Mark Barton on Bloomberg Television’s “On the Move” on Aug. 29. “A solution in Europe could be coming from the ECB if they were willing to do unlimited and unconditional purchases.”

Policymakers are fighting the last war. Incipient signs of stagflation will likely turn into intractable inflation or a deepening phase of stagflation once the next round of “unlimited and unconditional purchases” becomes a reality.

The ECB’s actions will then be likely complimented by the US Federal Reserve this September, and perhaps by other central banks such as BoJ, SNB and the BoE or even possibly China's PBoC soon.

These concerted inflationism by global central bankers could bring about the "worst of both worlds" for the global economy.

China-EU Deal: China may Buy EU Bonds, Bilateral Trade to be Settled in Yuan or Euro

China’s government promises to support the Eurozone by proposing to buy EU government bonds in return for expanded economic relations.

From Reuters,

China is prepared to buy more EU government bonds amid a worsening European debt crisis that is dragging on the world economy, Premier Wen Jiabao said, in the strongest sign of support for its biggest trading partner in months.

The debt crisis, which has dented demand for Chinese exports and dragged China into its worst downturn in three years, was the primary focus of talks between Wen and German Chancellor Angela Merkel who arrived in Beijing on Thursday.

The pair also concluded a flurry of business agreements, including a deal by China to buy 50 Airbus worth $3.5 billion, and multi-million-dollar investment deals involving Volkswagen AG and Chinese telecoms equipment maker ZTE.

But China’s pledge to backstop the Eurozone has been conditional.

More from the same article.

Wen said Beijing is willing to continue supporting the debt-stricken euro zone, and will step up talks with the European Union, the European Central Bank and the International Monetary Fund -- also known as the troika -- to help struggling EU nations.

"China is willing, on condition of fully evaluating the risks, to continue to invest in the euro zone sovereign debt market, and strengthen communication and discussion with the European Union, the European Central Bank the IMF and other key countries to support the indebted euro zone countries in overcoming hardships," he said after meeting Merkel.

Wen, who did not elaborate, said he remained worried about the crisis in the euro zone.

"Recently, the European debt crisis has continued to worsen giving rise to serious concerns in the international community. Frankly speaking, I am also worried," Wen told a news conference.

"The main worries are two-fold: first is whether Greece will leave the euro zone. The second is whether Italy and Spain will take comprehensive rescue measures. Resolving these two problems rests with whether Greece Spain, Italy and other countries have the determination for reform."

China’s government made the same promise before but domestic politics proved to be an obstacle

China Central Bank Governor Zhou Xiaochuan said Beijing would continue buying European government debt in February, but various Chinese agencies, including the sovereign wealth fund, countered the remarks by saying such investments were not wise due to risks.

The article does not elaborate whether China’s central bank pursued to fulfill on the pledge, or deferred until a comprehensive package has been contrived at.

My guess is that the kernel of the current deal of support by China to the EU, may have been set on the condition that bilateral trade will be settled mostly with the use of the yuan and or the Euro.

Both countries also agreed to settle more bilateral trade in the euro and yuan, as Beijing welcomed investments in China's interbank bond market by German banks, and the issuance of yuan-denominated financial products in Germany.

In short, the EU-China accord will work on bypassing the US dollar.

Given the marked slowdown or increasing signs of hard landing in China, it is not clear if China's government will undertake to buy significant amounts of EU bonds.

Nonetheless my guess is that the pact lays the foundation for the expanded use of China’s currency, the yuan, as international medium of exchange and as potential reserve currency, the reduced role of the US dollar, and the evolving balance of geopolitical power.

Explaining Super Mario’s Trifecta

The Buttonwood’s Notebook columnist (Philip Coggan) of the Economist provides a presumable explanation of last week’s rally following ECB Prez Mario Draghi’s pledge to do “Whatever it Takes to Save the Euro”

AN interesting note from the always-perceptive Dhaval Joshi at BCA Research shows that July was a remarkable month. It was the only month in the last 400 in which European stocks, the German 10-year bund and gold rallied by more than 2.5%. Even when Mr Joshi uses a lower 2% hurdle, the last simultaneous rally on this scale was February 1987, and there have been only seven such months in the last 30 years.

Normally, you would expect the conditions for a simultaneous rally to be rare. Inflation would be good for gold and bad for bonds; a recession would be good for bonds and bad for equities and so on.

Super Mario was partly responsible for July's trifecta with his promise to do whatever it takes to save the euro. Equities rallied on the hope that Europe's economy would avoid a catastrophe; gold rallied because the ECB would likely create money; and bunds rallied because the ECB would save all the costs of Spanish rescue from falling on the German taxpayer. or at least that is a plausible explanation, based on the fundamentals. An alternative is that this was a risk-on rally in which investors moved money out of cash and into any likely asset class.

I may add a more important dimension to the above explanation: shorts had been deliberately set up for the ambush

One example: Euro shorts collapsed by 10% in one week and 35% in one month.

Notes the Zero hedge,

And where two months ago, the net short position in the EUR hit an all time record, north of -200K contracts, in the interim this number has contracted by over a third, and as of minutes ago was revealed to be "just" 139K in the week ending July 31, a 10% drop in shorts in one week. Why is this important? Because while short covering rallies have long been yet another narrative to keep shorts on the sidelines, the probability of such an event has declined dramatically now that the bulk of the weak hands have been kicked out, and the net exposure is back to January 2012 levels.

Underneath all the supposed noble sounding rhetoric to save the Euro, interventionism has mostly been about price controls or the manipulation of markets.

Has Friday’s Surge by the US Stock Markets Been about the ‘Positive’ Jobs Report?

That’s how media paints it.

This Bloomberg headline serves as an example “Dow Posts Longest Weekly Rally Since October After Jobs Report”

Here is an excerpt: (bold emphasis mine)

U.S. stocks rose for a fourth week, giving the Dow Jones Industrial Average the longest rally since October, as better-than-forecast jobs data erased a four-day drop amid investor disappointment with global stimulus efforts.

Technology companies climbed the most among the 10 industry groups in the Standard & Poor’s 500 Index. Apple Inc. (AAPL) jumped 5.2 percent amid speculation the company may join the Dow, while First Solar Inc. (FSLR) soared 18 percent on surging profit. Better- than-expected earnings at MetLife Inc. (MET) and Frontier Communications Corp. (FTR) sent their stocks up at least 9 percent. Knight (KCG) Capital Group Inc. plunged 61 percent after a trading error spurred a $440 million loss.

The S&P 500 added 0.4 percent for the week to 1,390.99. The benchmark index for American equities extended its 2012 gain to 11 percent. The Dow climbed 20.51 points, or 0.2 percent, to 13,096.17, the highest level since May 3.

“We’ve come to fall into this trap if you will, when it comes to central banks, we want something from them immediately and if we don’t get it, the market gets disappointed,” Mark Freeman, who oversees about $13 billion as chief investment officer at Westwood Holdings Group Inc. in Dallas, said in a phone interview. “At the end of the day, the fundamentals matter, and the fundamentals are doing OK.”

Equities reversed weekly losses on the final day, with the S&P 500 jumping 1.9 percent, after a Labor Department report showed American payrolls climbed more than forecast even as the jobless rate unexpectedly rose. The benchmark index slumped 1.5 percent in the previous four days as European Central Bank President Mario Draghi and Federal Reserve Chairman Ben S. Bernanke failed to reassure investors on immediate efforts to bolster the economy.

The unemployment data ROSE despite the better than expected payroll figures? How’s that?

That’s because many people dropped out of the labor force.

From CNN Money: (bold emphasis mine)

Employers said they added 163,000 jobs in the month, according to a Labor Department report released Friday, much better than the 95,000 jobs economists had forecast.

But at the same time, the unemployment rate unexpectedly rose to 8.3% as households claimed they lost 195,000 jobs.

The government's monthly jobs report comes from two separate surveys: one that looks at employer payrolls, and the other which questions households. Those two reports went in opposite directions in July, confusing the overall reading on the job market.

"There are two sides of this report, and unfortunately both sides are not telling us the same thing," said Ellen Zentner, senior U.S. economist for Nomura. "This is a report showing the economy expanded at a greater pace in July than in June, but households are still telling us they're in pain.

How will “fundamentals matter” if the US economy and the financial markets have been heavily dependent on the Fed's steroids, as if to imply that monetary policies have neutral or only positive effects on the economy and the markets? Such observation is unfounded: the US Fed's balance sheets have ballooned but unemployment and economic growth remains sluggish.

Yes the CNN interprets the report as “confusing” even as the markets allegedly saw them as substantially positive.

Some positive developments eh?

Yet the breakout by the US stock markets seem to lack support as seen from internal market dynamics.

Bespoke Invest has a nice insight: (chart theirs too) [bold mine]

While the S&P 500's price has been in a steady uptrend, cumulative breadth for the index has actually been pretty weak. As shown in the lower chart, with each successive higher high in the index, breadth has actually been making a lower high.

Typically, it is optimal to see breadth trends confirming the moves in price, but the recent narrowing of breadth is indicative of fewer stocks participating in the rally, and likely a sign that more managers are underperforming.

“Fewer stocks participating in the rally” means two things for me, one the insufficiently supported rally could signs of developing weakness rather than strength; although most of the buying seems to have been directed at index heavyweights—Could the Fed or proxies of the Fed be behind this (too big to fail banks or the Plunge Protection team), ala the Bank of Japan via ETFs?

And second such could also be indications of distribution days.

Table from Bloomberg.com

Bottom line: I would put more weight in the interpretation of Friday’s hefty index-based US stock market rally as a “sympathy move” to the monster rebound (see the above table) by the Europe’s equity markets based on the mounting expectations of the imminent unveilment or announcement of the ECB-EU’s big bazooka.

Will the Accord by the ECB-EU Politicians Pave Way for the Big Bazooka?

Amazing volatility.

Graphics from Bloomberg

European markets appear to skyrocketing (after yesterday’s deep slump) on the proposed accord by the ECB and EU politicians.

From Bloomberg, (bold emphasis added)

After 2 1/2 years of incremental crisis management and false starts, a bargain is beginning to emerge between Europe’s politicians and central bankers over how to calm bond markets and end the debt tumult that threatens the euro’s survival.

The European Central Bank sketched out its side of the deal yesterday, offering to buy Italy’s and Spain’s bonds on the market as long as the euro governments’ bailout fund makes purchases directly from the two countries’ treasuries and ties them to tough conditions.

ECB President Mario Draghi offered only a glimpse of the new strategy, with the actual interventions weeks or months away and a host of obstacles standing in the way before Europe can claim to be on a path out of the crisis that emerged in Greece in late 2009. Investors looking for a quicker fix pushed down the euro, European stocks and bonds of at-risk countries.

“All of the announcements, if transferred into actual activity, would be close to the big bazooka approach that the markets are looking for,” said Charles Diebel, head of market strategy at Lloyds Banking Group Plc in London. “Market disappointment is hardly surprising in this context but we may well find this lays the groundwork for the grand plan in coming weeks.”

The conditions set by the ECB on EU governments, again from the same article…

A bond-buying program would require Italy and Spain to make austerity and economic-reform commitments -- or potentially only restate the ones they’ve already made -- and submit to international monitoring. Spain has already gotten over the stigma of relying on outside help by tapping a 100 billion-euro program to shore up its banks.

Draghi’s pledge took the ECB further away from its roots as a politically autonomous central bank, modelled on Germany’s Bundesbank, with prime responsibility for containing inflation and only a lesser focus on the broader economy and the stability of the banking system.

The Bundesbank’s leader, Jens Weidmann, was alone on the ECB’s 23-member policy council in expressing “reservations,” Draghi told the press. For now, Weidmann stayed silent, contrasting with the objections to the ECB’s original bond- purchasing program that were immediately voiced by his predecessor, Axel Weber, in May 2010.

I really doubt if the prospective deal will be complied with.

The political institutions of the EU have broken much of the self-made/imposed regulations (e.g. Maastricht criteria, changes in collateral eligibility rules and etc...) to accommodate the interests of the political authorities and the banking cartel.

Yet such agreement seems as justification for the deployment of ‘big bazooka’ inflationism, perhaps through the reactivation of the Securities Markets Programme (SMP) that would only defer on the day of reckoning or to buy time for whatever political reasons.

And I also think that the team Ben Bernanke and the US Federal Reserve may not be pulling the trigger for QE 3.0 perhaps until after the ECB-EU’s joint actions.

More from the same article,

One reason Draghi had to buy time is that European governments won’t be able to act until at least mid-September, the earliest possible startup date for the planned 500 billion- euro permanent rescue fund, the European Stability Mechanism. It faces a German supreme court ruling on Sept. 12.

Until then, Europe’s only rescue vehicle is the European Financial Stability Facility, with as little as 148 billion euros left over after last month’s approval of Spanish bank aid.

So the likelihood is that the deal will likely prompt Spain and or Italy to access the EFSF (temporary fund) first, from which the ECB may provide bridge financing until the ESM (permanent fund) is ready. Yet political authorities seem to optimistically think that these would be enough to deal with the crisis. They are most likely to be mistaken.

It’s just incredible to see how financial markets respond like a pendulum—swinging from one extreme end to another—in the collision of expectations from promises to inflate as against the reality of unsustainable arrangements and of the ongoing economic recession in the EU.

One might just easily generalize that financial markets have almost been rigged by the central banks.

Nonetheless, all talk about the prospective actions by the ECB-EU seems to have scarcely influenced on the price actions of gold and oil. While both are up signifying a return to the risk ON mode, the degree of gains have not been the same as the equities. Could gold be sensing something else?

Be careful out there.

Will this Week Highlight the Climax for the Euro Debt Crisis?

Will the Euro debt crisis see its climax this week? The head of the Eurogroup Jean Juncker thinks so…

From Marketwatch.com

The head of the Eurogroup, Jean-Claude Juncker, said the countries sharing the common currency, their rescue fund and the European Central Bank will soon act to save the euro, according to a pre-release of an interview to be published Monday by Sueddeutsche Zeitung.

"We will decide in the coming days which measures to take," Mr. Juncker is quoted as saying.

Mr. Juncker indicated the European Financial Stability Fund and the ECB will buy Spanish government debt to bring down yields after a summit of euro-zone leaders in late June had paved the way for sovereign-bond purchases by the bailout fund.

"I have no doubt that we will implement the decisions of the last summit," Mr. Juncker said, according to the newspaper.

His statements seem to be the first official confirmation of media reports that European leaders are drawing up a plan of purchases of Spanish and Italian government debt by the ECB and the rescue fund.

"The euro countries have reached a point at which we have to make clear with all available means that we are strongly determined to ensure the financial stability of the currency union," the German daily quotes him as saying.

"The world is talking about whether the euro zone will still exist in a few months," Mr. Juncker said, according to Sueddeutsche Zeitung.

Despite a gamut of bailouts, Euro’s debt crisis has lingered since 2008 and have been worsening,

The belief that a political solution will arrest the crisis, like in the recent past, will likely be just another delaying the day of reckoning, that would go against the central designs of the political masters—Messrs. Junker, Draghi, Hollande, Ms. Merkel and the rest, and this includes team Ben Bernanke of the US Federal Reserve, whom has been working closely with the ECB—to prop up the unsustainable political welfare-crony system.

But of course, real actions from central banks will have real effects in the marketplace and in the economy. And this is why the details of what they will do will greatly matter.

Global financial markets have priced in heavily the expectations of the coming massive bailout by the ECB.

So political actions will have to deal first with the market’s expectations. The failure of which may result to the magnified market tremors which could swiftly eviscerate gains we have seen in the recent days.

Next, financial markets have become extremely complacent and heavily dependent on steroids. Bad new has been interpreted as good news.

Growing signs of political desperation by Euro officials have only reinforced the market’s HOPE of a political fix from political narcotism (inflationism) even when unfolding events keeps us telling us the opposite.

Financial markets have been reduced to a branch of a grand casino according to ex-US President Reagan’s former budget director David Stockman

Not only will this mean sustained volatility of market pricing—out of the repeated price distortions from widespread interventions—such complacency amplifies the fat tail risks (or a market crash). Of course I hope that this won’t happen.But the risk environment or conditions says that this is a possibility.

But hope would not serve as a better guide for prudent investors, instead, we should prepare for the worst while hope for the best

Be very careful out there.