We have a lot of data and commentary to plow through these days, but two main points need to be kept uppermost in mind. First, the US absolutely, positively needs to address that debt is 100% or more of GDP. The US weathered a rating agency downgrade once, but another downgrade could have far worse consequences, including a market-driven rise in yields that would be costly and could easily offset revenue increases if they are only modest.
Secondly, it’s official--Europe is in recession. As noted in the “sanity check,” this has been coming for a long time and now it’s here. That the euro didn’t fall on the news release is a function of the data already having been built in and also the technical condition of the charts. We were due for a corrective bounce. As we often see, “buy on the news” was in play. And watch out—buy on the news will be in play again when Greece gets its bailout funding and to a greater extent when Spain finally asks for its own bailout. This is the famous perversity of the FX market—bad news is treated as good news.
But don’t be fooled—the bad news really is bad and has important and far-reaching implications. The most immediate is the question of whether the ECB would or could cut interest rates, and soon, like December. Conventional analysis says the ECB should cut. The Teutonic version has it that the ECB must not cut as long as inflation is over 2%--and it is. Another implication is that the EMU chooses not to engage in Keynesian policies, whatever the recessionary conditions. Taking on more debt to boost growth is a non-starter. Some analysts see the choice as opening the door to ideological debate, but let’s not go there. The unhappy fact is that only Keynesian pump-priming has ever been shown to be effective. It’s obviously counter-productive to insist on austerity and then hope to keep tax revenues the same or rising. No amount of shell games, robbing Peter to pay Paul, can subtract anything from this simple truth. A third implication is that if economies are contracting, what is happening to banks? It was only a few months ago that the chatter was about French banks need massive recapitalization and facing downgrades (and re-activation of the Fed swaps, etc.). The mind boggles at the emergencies that can pop up.
This means, at a guess, that the US and Europe are on diverging economic paths that suggests diverging political and social developments, too. We don’t yet know what that means. So far it seems to mean the re-emergence in Europe of nationalism, anti-immigrant sentiment, and the like. What else is out there? It won’t be long before scape-goating turns to the US (and probably Israel). We are accustomed to seeing street protesters with signs saying “Down with the US” in places like Iran and Pakistan. We will be shocked and unhappy to see them in the streets of Athens and Madrid, or Berlin.
Bottom line—if the US government manages to get a fix of the fiscal cliff, and not just any old fix but a fix that passes muster with investors and ratings agencies as well as voters—the dollar should get a base of support. For once it may be in conjunction with equities. We have long argued that the supposed inverse correlation of the dollar and equities lacks logical substance and can work only if we consider that rising equities reflect a world safe for risk, which in turn depends on decent economic conditions in the US. It’s beyond counter-intuitive—it’s nuts--for the dollar to fall when economic and institutional conditions are improving. In a way, the dollar is the victim of good economic conditions as traders look for yield in emerging and frontier markets. But every once in a while, good outcomes favor the dollar and this could be one of those times. Maybe.
The EMU sanity check:
- The eurozone is officially in recession, with Q3 GDP down 0.1% after -0.2% in Q2. The IMF predicts a 80% probability of eurozone recession in 2013. The European Commission say 2012 growth will be 0.4% and cut its eurozone growth forecast to 0.1% in 2013 from 1% in May. German growth was cut in half to 0.8% from 1.7%. France will contract by 1.4%.
- S&P cut Spain's rating two notches to triple-B-minus, one step over junk, and Moody’s has the same rating (Baa3), also one notch over junk. Moody’s cut the ratings of half the Spanish regions. S&P cut the SocGen rating by one notch and issued a negative outlook for the other two big French banks on deteriorating conditions.
- The EU banking supervisor will be established by year-end but may not have the authority to recapitalize the Spanish banks for another 6-12 months.
- Greece needs the additional €30 billion in bailout money. The deadline is a bond redemption on Nov 16.