Faith, Hope, And Draghi

What can we say? From the better than expected GDP this morning Gold and the USD (and Treasury yields) diverged from the QE hope trade – but stocks didn’t. Then came the statement of the entirely sublime obvious from someone somewhere about Draghi’s normal pre-meeting meetings and we were off to the races to test recent highs. Treasuries exploded higher in yield, Gold popped, USD weakened (as EUR popped), and stocks ripped. But…Treasuries reverted back to pre-Draghi-levels, EUR tumbled and the USD ended near the highs of the day, Gold gave back most of its spike gains and closed in the middle of its day’s range as stocks just wouldn’t give up the dream. For a 2% rally in S&P 500 e-mini futures, VIX fell only modestly by 0.9 vos to 16.7% – which is above last week’s close (while stocks end almost 2% above last week’s close). Amid the heaviest volume in over a month and the largest average trade size in over a week, ES closed at almost 3-month highs. It appears to us that unless Draghi and Bernanke – who now seem engrossed deep in the inter-continental thermonuclear currency war – both do their bit next week (which the market has now more than fully priced in given the dismal fundamentals) then this is becoming farcical but as Maria B said “a rally is a rally, right?” Ask the ZNGA and FB buyers of the rally on IPO day. Stocks ended the day notably decoupled from risk-assets amid Treasuries worst day in 9 months.


Gold has overtaken the Long-Bond year-to-date now (only the 4th close this year) as stocks just go about their business at 3-month highs…


The S&P 500 e-mini rallied strongly to its uptrendline but once we broke an intermediate trendline there was heavy block trading into the highs (h/t @eminiwatch) – does make us wonder exactly who was chasing this into that second top of the day…


10y Treasury yield soared (on a percentage basis) the most in over nine months…tracing back to their 50DMA… (and as an aside the spread between 30Y mortgages and 10Y TSYs is at a six-month tight)…


Equities and Treasuries recoupled as did Gold and the USD – though the disagreement was clear…


as Treasuries in general have retraced most of their gains from pre-EU-Summit…


as despite today’s U-Turn in the EUR, the USD ends the week -1%…


I guess that is the price stability Draghi is looking for..but compared to capital structure (rates/vol/credit – left) and broad-risk-assets (right) we disconnected – especially in te last few hours of retest…

Charts: Bloomberg and Capital Context


Bonus Chart: Spot The Odd Market Out… This chart shows inverted stocks (black) against VIX, implied correlation, and VIX futures… can you see which one has gone full retard?

On Europe’s Broken Transmission Channels

There are many channels through which changes in the monetary policy stance are transmitted to the real economy. Recent statements by Draghi and Noyer (and a dropped word by Nowotny) suggest that the ECB is concerned about the uneven transmission of its July interest rate cut to bank lending rates across the Euro area. Goldman finds this empirically true noting that the influence of official ECB rates on retail interest rates in Italy and Spain has diminished, while it has increased in Germany and France and in fact there is a ‘reversal of policy transmission’ in Spain and Italy, whereby ECB rate cuts are now associated with an increase, rather than a fall, in retail rates (as the rapid deterioration in peripheral banking systems has more than offset any impact of lower rates). This ‘failure’ of standard monetary policy to ease conditions has led to the non-standard measures being discussed now. We see three points from this: rate cuts are less likely than the market believes; while SMP is now being priced in, it doesn’t specifically address the transmission-mechanism; and just as Draghi hinted at in his last conference, we suspect he will reiterate his reduced collateral standards and increased eligibility to private-sector loans directly (an LTRO 2.5) – which, however, will necessarily encumber bank balance sheets even more (if Zee Germans will even agree to it).



Goldman Sachs: Broken transmission and non-standard ECB policy

Recent statements by ECB President Draghi and Banque de France Governor Noyer suggest that the ECB is concerned about the uneven transmission of its July interest rate cut to bank lending rates across the Euro area. Consistent with this view, this week we demonstrate how sovereign tensions have segmented financial markets in the Euro area, thereby increasing the divergence of bank lending rates across countries, and hindering the uniformity and transmission of monetary policy.

We highlight two main empirical facts. First, during the financial crisis the influence of official ECB rates on retail interest rates in Italy and Spain has diminished, while it has increased in Germany and France. Second, we observe a ‘reversal of policy transmission’ in Spain and Italy, whereby ECB rate cuts are now associated with an increase, rather than a fall, in retail rates. This observed reversal should not be read as implying that monetary policy now has perverse effects on demand in the periphery. Rather, it suggests that the tightening effect of a sharp deterioration in the state of the peripheral banking system and financial markets has more than offset the impact of lower official rates.

As a result of these considerations, we conclude that the ECB’s July rate cut has failed to loosen financing conditions in the periphery, where stimulus is most needed. A blocked interest rate channel of monetary transmission makes it less likely that the ECB will implement further rate cuts. In line with Mr. Draghi’s recent comments (see European Views, July 26), re-establishing transmission through non-standard monetary policy measures to restore market functioning appears a more appropriate line of policy action.


Broken link between official, market and retail interest rates

There are many channels through which changes in the monetary policy stance are transmitted to the real economy. Here we focus on what has traditionally been seen as the main channel: from changes in central bank official interest rates to changes in market rates (in money and sovereign markets), and on to the final (or retail) interest rates that banks charge on loans to their customers.

In normal times—when financial markets are unified and functioning properly—ECB rate decisions exercise close control over banks’ refinancing costs in the money markets throughout the Euro area. And, albeit with lags of varying length, refinancing costs are passed on by banks to their borrowers: in the end, interest rates on loans and mortgages follow the policy rate in a uniform way across countries.

But, in the context of the ongoing crisis, financial markets have become dysfunctional. This has led to an impairment of monetary policy transmission in general, and of the traditional interest rate channel (described above) in particular. Reflecting this, in a recent speech Banque de France Governor Noyer noted that July’s ECB rate cut had been passed through to borrowers unevenly across Euro area countries: sovereign tensions had segmented the money market, leading to different financing conditions in different jurisdictions.

Here we explore how the relationship between policy rates, money market rates and sovereign yields has evolved over the crisis period and the implications this has had for the variation in financing conditions across Euro area countries. Before the crisis, it was widely assumed in the economics literature that the evolution of longer-term market rates (notably government bond yields) did not exert much influence over the way banks set the interest rates they charge to their customers. Rather, monetary policy decisions have generally been considered to be the predominant driver of retail rates. This assumption mostly derived from the stability of sovereign yields themselves and the spreads between them, which introduced little volatility into retail rates. It was also believed that bank funding costs were only modestly affected by sovereign yields. The latter therefore had little impact on retail rates.

We start here from the assumption that the rate-setting behaviour of Euro area banks—and thus the transmission mechanism of monetary policy—has changed with the onset of the financial crisis, possibly in very fundamental ways. There are a number of inter-related potential drivers of this change, among which:

  • The banking system itself has become dysfunctional in the peripheral countries.
  • The dislocation in government bond markets has affected bank funding costs through several channels, for example:
    • Because of the interconnectedness of bank and sovereign balance sheets, developments in sovereign bond markets (widening and volatile spreads, liquidity strains) also affect wholesale refinancing costs (as can be seen from the persistently elevated CDS for European senior financials).
    • The dislocation of government bond markets erodes bank capital: for holders of government debt, capital losses are incurred as yields rise. In a context where bank capital requirements have risen under the Basel III standards, this erosion of bank capital constrains credit expansion.


Changes in the behavior of retail interest rates


Up to the crisis, retail bank interest rates moved in lockstep (albeit with a spread, and after a lag) with changes in the ECB policy rates. The financial crisis has altered this picture. We now observe:

  • A new—and significant—heterogeneity across bank interest rates across countries. Spanish and Italian retail rates are much higher than French and German ones, as illustrated in Chart 1.
  • A decoupling of some retail interest rates from monetary policy rates (see Chart 2). Since the crisis, changes in ECB policy rates—and in particular the most recent sequence of interest rate cuts—have failed to be reflected in retail interest rates in the periphery, notwithstanding the non-standard policy measure implemented to unfreeze money markets and ease bank refinancing costs.1 As a result, while Italian and Spanish households and non-financial corporations are facing sharp increases in the rates they are charged by their banks, their German counterparts have been borrowing at rates that are declining in line with official rates.
  • A higher correlation between sovereign spreads and retail interest rates, as sovereign tensions have played an increasing role in shaping bank funding costs by country.



Exploring the ‘official-market-retail’ interest rate link

We now look in greater detail at the interactions of bank lending rates, official rates and sovereign yields. To do this, we have estimated a model relating retail bank interest rates to the level of ECB official rates and national government bond yields, controlling for short-term adjustments due to changes in official rates and sovereign yields.

We examine the evolution of interest rates on loans to the household and corporate sectors across maturities (between 1 and 10 years), and compare two sub-periods: before and after the start of the sovereign crisis, which we take to be May 2010 (the introduction of first Greek program). We confine our analysis to the ‘Big-4’ countries (Germany, France, Spain and Italy).

The results are summarized in Table 1. The long-term impact of market rates on each retail rate are shown in the first four columns (sub-columns (1) correspond to the period 2003-2010, while sub-columns (2) correspond to the crisis). We find that:

  • Most importantly, not only the size but also the sign of monetary policy transmission has changed in Spain and Italy. This can be seen intuitively from the divergence between retail interest rates and the ECB rate in Spain, shown in Chart 2. It is confirmed by the signs of the long-term coefficients on ECB rates: these turn negative for longer-term loans in Italy and Spain, even when controlling for the impact of sovereign yields (second column in Table 1). This evidence of a ‘transmission reversal’ should not be read literally. But it does point to structural problems in the banking sector. Over the crisis period, the deterioration in the state of the banking system—which is not captured in our model—had an impact on retail rates that more than offset that of lower official rates. For this reason, the ECB’s July policy decision failed to loosen financing conditions in the places where loosening is most needed.
  • The reaction of retail bank rates to national sovereign yields is not unique to the crisis. It existed before the crisis, but was not so obvious because sovereign yields were so stable and spreads so tight (see third and fourth columns of Table 1). (This relationship may help to explain the well-documented sluggishness in the response of retail bank rates to changes in the monetary policy stance.)
  • With the crisis, official ECB rates have lost their influence on retail rates in Italy and Spain, while they have gained influence in Germany and France. This can be seen from the fact that most long-run coefficients on official rates ceased to be statistically significant in Spain and Italy during the crisis.3 By contrast, the importance of the ECB policy rate has increased substantially (and has remained significant) in Germany and France.

Borrowers in the periphery feel the pain more quickly than before

Euro area retail bank rates have always proved sticky in the short term. This contrasts with the US experience, where retail interest rates are more generally indexed to market conditions and therefore move quasi-automatically with them (and thus with policy rates). Our analysis here suggests that retail bank rates have overall become less sticky since the onset of the crisis. This can be seen in the estimated adjustment coefficient shown in the last two columns of Table 1 (i.e., the parameter in the cointegration relationship, which captures the speed at which retail rates revert to their long-term equilibrium level over time).

ECB is likely to be more reluctant to use rate cuts

Our results suggest that the way Euro area banks set interest rates on their loans to households and non-financial corporations exacerbates the macroeconomic strains that are afflicting the periphery. Borrowing rates amplify and entrench the divergence of financial conditions across Euro area countries. Since the Euro area economy is still predominantly bank-financed, this retail divergence in financial conditions adds to that seen in wholesale markets, strengthening the centrifugal forces within the Euro area.

If the transmission of standard monetary policy measures were to deteriorate further and add to the forces promoting divergence of macroeconomic performance across Euro area countries, other things equal the ECB would be less likely to implement further interest rate cuts in coming months. Mr Draghi’s comments in London on Thursday 26 July (“within our mandate, the ECB is ready to do whatever it takes to preserve the euro.; and believe me, it will be enough.” cf. European Views, July 26) support our view that further non-standard monetary policy measures may be implemented in the near future, so as to improve the functioning of financial markets and improve monetary policy transmission.

A key open question is whether such measures will focus on attempts to revive the sovereign markets or rather set out to bypass them by offering more direct support to the private sector.

In the past, the former approach has embodied outright purchases of government debt by the ECB through its Securities Markets Program (SMP). But the resurrection of the SMP threatens to break the current internal compromise on the ECB’s decision-making bodies. And its effectiveness is open to question, given market participants’ concerns about subordination in the aftermath of the treatment of ECB holdings in the Greek debt restructuring.

The ECB may therefore look to support private-sector financing more directly, by further easing of collateral eligibility, increased liquidity support to the banking sector and outright purchases of private-sector assets originating in both the bank and corporate sectors.


Source: Goldman Sachs

The Ballooning Cyprus Fiasco

Wolf Richter

The government of Cyprus is desperate. It is deliberately slowing down paying its contractors. “We are talking about final payments and settling of bills for work that was carried out and passed through the inspections, and for which an order was issued for payment,” said Nicos Kelepeshis, head of the Federation of Associations of Building Contractors. 120 days, and more. The government also told inspectors to delay inspections in order to slow down payments.

In June, Cyprus had held its nose and requested aid from the Troika, those despised austerity thugs made up of the European Union, the European Central Bank, and International Monetary Fund that have, in Cypriot eyes, wreaked havoc in neighboring Greece. And this week, once again, these despised Troika inspectors are swarming over Cyprus to find out how much money the banks would need to deal with their putrefying balance sheets, and how much the government would need to stay afloat.

If a deal is reached—sticking point are the conditions, namely structural reforms, budget cuts, privatizations, and tax increases—the first bailout money might arrive in October. But Cyprus is bankrupt now! So, the government is raiding the “semi-state“ sector. Last week, it pilfered €101 million from the Cyprus Telecommunications Agency, €50 million from the Ports Authority, and €24 million from the Human Resource Development Authority. Now it’s going after the pension fund of the Electricity Authority to get a couple hundred million. This place is seriously out of money.

At first, it was just a funding crisis. After markets closed the door, Cyprus went begging to Russia and got €2.5 billion. That money has now evaporated.

Then it was the banks. In June, the Bank of Cyprus needed €500 million and Popular Bank €1.8 billion—in total €2.3 billion. A black hole in their regulatory capital had developed when they were forced to write down the defaulted Greek government bonds on their balance sheets [“We owed it to our children and grandchildren to rid them of the burden of this debt,” sneered Greek Finance Minister Evangelos Venizelos at the time as private sector investors got whacked with a 74% loss. Read…. “A harder Default To Come”].

But the banks were joking about the €2.3 billion. They’ve also been eviscerated by Greek corporate debt—40% of the loans on their balance sheets. They’re turning to trash as Greece slithers deeper into its fifth year of recession. Then there are the loans left over from the real estate bubble and title-deed scandal that the banks themselves colluded in. An estimated 130,000 properties are without title deeds—in a country with only 838,000 souls. Those who think they own these properties don’t legally own them. A nightmare gumming up the future of the country [I warned about it in October…. Another Eurozone Country Bites the Dust].

And so in June, as bailout talks with the Troika took off, the €2.3 billion were declared a joke. “Eurozone sources” mumbled something about €10 billion, including a government bailout, which hadn’t needed one before.

Cyprus has been trying to triangulate its bailout negotiations by adding China and Russia. They’re ogling the vast natural gas reserves found off the coast. Awash in natural gas, Russia is the major supplier to the EU through a system of pipelines, and it wants to keep control over its export market. China wants to grab resources around the world. And on July 6, Russian Finance Minister Anton Siluanov confirmed, “Yes, we have a request from Cyprus. They’re looking for €5 billion.”

So since Monday, the despised Troika inspectors have been plying their trade. And it didn’t take long for it to seep out that the banks alone would now need a bailout of €9 billion—a stunning amount for the banks in such a tiny country. Plus, the government would need €4 billion. For total package of €13 billion.

But the €9 billion for the banks is likely to grow even further—because bad debt isn’t bad debt in Cyprus. Under Cypriot rules, loans on the banks’ books that are over 90 days past due aren’t considered bad debt, and no losses have to be recognized, if the loans are secured. Hence, a mortgage that is in default doesn’t have to be written down because the bank might eventually obtain the property, which takes many years, and then sell it to recuperate its money. But property values have collapsed. And worse: the title-deed fiasco resulted in banks securing two or more mortgages with the same property—and only one of them has any value at all. But they’re all “secured”; hence, none have been written down.

The Troika inspectors are circling. They want those loans written down. Government and banks resist. The outcome of this clash will be a big factor in determining the bailout amount for the banks. And the government bailout of €4 billion will certainly rise. The first time is only the beginning—Greece, if it were to stay in the Eurozone, would require a third bailout. Standard and Poor’s tacked on some extra billions and came up with €15 billion. 83% of GDP. €18,000 ($22,000) per resident. Another bottomless pit. Is that why Russia and China haven’t jumped into the fray?

In the run-up to this crisis, people have gotten rich and taken their money to Switzerland. What’s left is debt. But instead of letting it blow up and disappear, wiping out creditors and equity holders in the process, it’s being replaced with new money, but from taxpayers elsewhere: 29% from Germany, 22% from France, even from teetering Italy and Spain….

But Spain is on the brink. The word is out: default. Or bailout. Read…. The Extortion Racket Shifts to Spain.

And here is a great perspective by George Dorgan, a portfolio manager in Switzerland who used to live in Italy. Read…. Italian Euro Exit: why it might come in 2-3 years and why it will help the Eurozone and Italy.

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