Wednesday, November 30, 2011

Markets Seem to Be Rallying On a Sign Things Might Be Getting Worse

Overnight there was a dramatic intervention by an alphabet soup of central banks.  The Fed, ECB, BOE, BOJ, SNB and Bank of Canada all lowered their swap rates making it cheaper for local (non-US) banks to borrow dollars.  Even the Bank of China got involved, dramatically lowering their reserve ratio by 0.5%, the first lowering in 3 years (yup the banner year that was 2008).  This sort of massive coordination is never easy and is a sign of severe stress in the system. A writer at Forbes mentions the possibility that this could have been done to avert the imminent failure of a large European bank, which would have caused a Lehman like cascade through the system.   Considering this is the second massive central bank intervention involving US dollars in the span of less than 3 months, this is probably at best a kick the can down the road sort of scenario.  And lately the can just hasn't gone very far at all.

The big problem is that we are simply not facing a liquidity crisis.  We are facing a sovereign debt crisis which could eventually lead to a solvency crisis.  Pumping more dollars into the system won't help unless somehow people use those dollars to buy Italian, Greek, Spanish and French debt.  And they won't.  As the folks at GaveKal mentioned, sovereign debt investors are usually the types who will give a well funded government $100 with the assurance that they will be getting $102 in a year.  These are not swing for the fences, high risk, I've-got-a-feeling-on-this-one types.  Essentially, the natural market for EU sovereign debt has disappeared.  So how are these governments going to fund their operations over the next year given their 100%+ debt/gdp ratios?  How can they roll over hundreds of billions of dollars worth of debt?  What happens when they default and force banks to mark bonds to market, wiping out bank capital and causing a solvency crisis (remember MF Global was taken under by Italian sovereign debt)?  None of these issues have been solved by this intervention to lower the rates charged to borrow dollars.  In fact, if this intervention shows anything it is how close to the brink we really are.  Stay nimble and stay liquid.

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