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Friday July 9, 2010 - 01:34:53 GMT
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Forex Blog - ECB's Medicine May Kill Patient (FXA)

Watching Trichet’s press conference today, I was struck with his confidence in the (EZ) world coming together…bank liquidity, real economy, fiscal adjustment and the policy response are all in alignment and proving markets (people like me) so dreadfully wrong.  If anything he was cocky…relishing his achievement having threaded the policy needle.  He even responded to a question on the World Cup semi-final between Spain and Germany Wednesday noting how beautiful the game was played by both sides and the fact that 3 of the 4 teams in the semi-final brackets were European (Euro Zone) and the all-EZ final Sunday.  I could not help but think he was using the Spain-Germany match Wednesday as a metaphor for the Euro Zone…no yellow cards, no red cards, both sides fully respecting each other and only winners at the end of the day.  Clearly if you are a fan of Germany there was nothing beautiful about its team’s performance…none of the flare demonstrated in one-sided wins against England and Argentina.  Nonetheless, beautiful is also an adjective in soccer-ese to describe Brazil’s style of play…not Germany (the technical game) and not Spain (the passing game).  But Brazil’s economic fundamentals are sound and maybe Trichet delighted in this metaphor for EZ fundamentals…EZ getting it right after a near euro disaster as Brazil did after the 1999 real crisis. 


Not only did Trichet restate his support for fiscal adjustment across the EZ (and peaking in 2011) which according to most policymakers in Europe will boost growth rather than reduce it (keep market rates low), but he also gave a full-throated endorsement to the rise in EZ market rates asserting it reflected a normalization in bank funding and liquidity.   And without adding any details to what European bank regulators released late Wednesday on the upcoming bank stress tests for 91 of Europe’s largest banks, he appeared to be gloating over the process confident of its success and scornful of market naysayers who bet wrong on sovereign debt crisis response and now wrong on the bank adjustment process.  Indeed he called on banks to retain earnings (as opposed to paying dividends), turn to capital mkts to strengthen capital bases or take full advantage of government support measures for recapitalization.


The ECB President also noted that new rules on ECB collateral will be published soon to address the issue of banks posting some of their weakest assets as collateral with the ECB for loans (expected July 22, just a day ahead of the results of the stress tests).  Sensing a return to normalcy in the European banking system, the ECB is clearly eager to get rid of the tons of toxic collateral the banks have posted for loans and take in better quality collateral ahead…and with the weak collateral going back to the banks and priced at a far lower mark, the banks will be forced to write down some of these assets or set aside reserves against losses.  So the ECB will have higher haircuts in place for things like BBB rated collateral. 


Frankly I find Trichet’s basic premise seriously flawed.  I don’t think the Euro Zone economy and banking system, and hence asset prices, can withstand a frontal assault on liquidity in the banking system and a simultaneous withdrawal of government stimulus.  No I am not a double dipper – but I am a global stagnation believer and see little positive ahead for growth in the developed economies.  There is no beautiful game for Europe ahead. 


If banks face pressure to write down collateral that they no longer can place with ECB for loans at above market rates, they will be constrained from taking risk…read creating credit…something they still have not begun to do with “old” or “crisis” collateral rules.  Moreover, as liquidity leaves the banks in reduced demand for ECB funds at LTRO’s and MRO’s, this could hide some bifurcation in the banking system…some banks are in better shape than others and on a net basis the demand for unlimited ECB funds is down, while hiding the fact that it remains elevated for the weakest banks.  Also, the rise in euro LIBOR (toward ECB’s 1.00% refi rate) represents a tightening of monetary conditions.  After May and June, the last thing European banks need is tighter monetary conditions. 


And even if Trichet can seize on German industrial production in May while ignoring a decline in German industrial orders in May as a sign of the economy gaining momentum, I think if the US economy slows to 0-1% GDP in 2H of 2010, Europe will not escape unscathed. 


Finally, I think Trichet’s assertions on the return to normalcy in the banking system, based on some banks facing less funding pressures rests on the belief that the credit creation process is up and running when in fact it remains deeply impaired.  If I had to bet I would expect the tightening of fiscal policy and monetary conditions to ultimately expose the weakest of the banks and may rekindle the next wave of the EZ crisis. 


Now not all is bad in Euroland.  In a cryptic choice of words, Trichet seemed to open up the question as to how the Euro Zone’s massive stabilization fund could be used.  In other words it may not simply be available for supporting state financing in the event sovereign can’t sell debt in the capital market.  To me this means there is an active debate among policymakers to make the stabilization fund available to the banks as a source of capital – not unlike what the US Treasury did with TARP.  That would be worth celebrating. 


Finally, I am not tone deaf…markets have clearly given European officials the benefit of the doubt on fiscal adjustment and normalizing banks.  Mark this one down to an adaptive expectations moment for capital markets…what was good for the goose (confidence in US economy and equities or risk in 2009) is good for the gander (confidence in EZ economy and equities or risk in 2010).  Unfortunately, I seriously doubt that European officials are anywhere close to the scale of the policy response that US officials put in place in 2008 and 2009 and the European problem today is not that much smaller in scale than the US problem in 2008 (ECB is boastful it has not had to turn to either ZIRP or QE). 


I don’t think the current rally in risk associated with greater confidence in Europe’s banks and economy and lesser confidence in the US economy is sustainable.  Indeed the very medicine Europe’s officials are deploying (fiscal contraction and tighter monetary conditions) could kill the patient.  And I also can’t help but notice that 16 months since the US bank stress tests, fiscal stimulus (still in place) and ZIRP and QE from Fed the US recovery is more in doubt today that at anytime since mid-2009 suggesting to me that even the massive US policy response may not have been scaled sufficiently large enough to match the scale of the crisis.


David Gilmore


PS Would sell any EURUSD rally in 1.28 area and look for top to build there and downside target would be 1.23 for end-July.


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