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Economic Reality: Nowhere to Run, Nowhere to Hide, Part 2


The onset of the Global Sovereign Crisis marks a new dangerous phase of the credit crisis.

The risk of losses from a Greek or other sovereign defaults has affected financial institutions. Mirroring events at the start of the GFC, the close linkages between eurozone banks through cross-border loans and investment to each other remain a serious potential problem. The stress is most evident in inter-bank funding rates that have risen sharply to their highest levels in a year.

Since 2008, money markets have operated on the basis that large banks are "too big to fail," due to support from the relevant sovereign. The problems of sovereigns themselves have heightened concern about the credit risk of banks. Banks fearful of the quality of borrowing banks may limit lending.

Banks, especially those in Europe, are paying higher interest costs and may face difficulties in raising funds. The ECB recently warned of the problems faced by European banks in financing their operations and refinancing maturing debt. Markets are stockpiling liquidity, as evident by surplus balances at the ECB and other central banks, fearing a sequel to the deep freeze in financial markets in 2008.

Activity in bond markets and new equity raisings have slowed sharply.

In the real economy, forced or voluntary retrenchment of government spending is restricting demand restraining economic growth. Lack of demand in Europe affects the exporting economies of Japan, China, and East and South Asia.

Currency volatility, dominated by the appreciation of the dollar, is creating problem. It's driven by a flight to quality, away from euros and yen to dollars. It's also driven by a forced de-risking as traders unwind the carry trade (long risk/short dollars). The Australian dollar, which has been masquerading as a respectable currency, reverted to the peso of the South Pacific, falling an astonishing 12+% in a few days. Concerns about commodity prices and Chinese growth accelerated the fall.

Dollar strength belies the economic fundamentals and will slow the ability of the US to use exports as a growth engine. The weakness of the euro and resultant appreciation of the renminbi by 14+% also reduces Chinese exporters' earnings and competitiveness. China is now even more reluctant to take steps to allow the renminbi to appreciate.

The sovereign debt problems are creating serious dislocations and perverse outcomes. Paralleling the events after the Asian monetary crisis in 1997/1998, the flight to dollars has pushed down interest rates on US government debt. Paradoxically, lower interest rates reduce pressure for deficit reduction by lowering the cost of servicing public debt.

Fading Hopes

A combination of self-reinforcing events is driving a pernicious reversal of the dynamics of 2008-2009. Then, coordinated government action on a grand scale stopped the global financial crisis from turning into a depression. Government and central bank strategy was a bet on growth and inflation, as the most painless means of adjusting the overly leveraged and deeply indebted global economy. In the words of François Duc de La Rochefoucauld: "Hope, deceitful as it is, serves at least to lead us to the end of our lives by an agreeable route." Now, governments have become the problem, perhaps calling time on the wishful thinking of markets.
No positions in stocks mentioned.

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