November, Wednesday 23, 2011

DOW – 236 = 11,257
SPX – 26 = 1161
NAS –61 = 2460
10 YR YLD -.06 = 1.88%

OIL – 2.19 = 95.82
GOLD – 7.10 = 1693.30
SILV – 1.01 = 31.86
PLAT – 23.00 = 1554.00

Today’s lesson is on basic supply and demand. Let’s say you manufacture widgets; and let’s say you produce 100 widgets and you have enough customers to sell all 100 widgets. Now let’s say that you start producing 1,000 widgets, even though your market hasn’t changed. What happens to the price of each widget? That’s right, the price of widgets goes down, and you might not be able to sell all the widgets you’ve produced.

Yesterday the IMF said they would backstop European nations with loans up to 10 times their quota. Now imagine that you are a European nation trying to sell bonds and the IMF just announced that the supply of bonds might increase by 1,000%. What happens to the price of each bond? That’s right, the price of bonds goes down, and you might not be able to sell all the bonds you’ve printed.

Germany held a bond auction this morning; they failed to get bids on 35% of the 10 year bonds that were offered for sale. The auction was basically a disaster. Germany is the strongest nation in Europe and if they have this kind of difficulty in raising capital then you have big questions about upcoming auctions in other Euro countries. 

Wait a second; Germany has Europe's strongest economy, and traders have bought its debt as a safe place to store value during turbulent times. Here’s the problem: Germany bears much of the burden of bailing out weaker and smaller neighbors, such as Greece and Portugal.

And borrowing costs for Italy and Spain rose from levels that already were considered dangerously high. Europe lacks the resources to bail out those countries, which have its third- and fourth-biggest economies in the Euro zone.

The ECB has been active in the bond market as a buyer, but only in a limited way. The French, British and US want the ECB to act like the Federal Reserve overwhelming the market, and monetizing to solve the problems of the moment. The Germans do not want to deal with the inevitable inflation that follows. The extension of the problem, the hallmark of US, UK and French monetary policy obviously doesn’t solve the problem, but eventually compounds it by creating more debt and inflation. This policy has proven over and over again to be a failure in the longer term.

Confusion still reigns in Europe, and as a result the euro has lost 3%. In fact, climbing interest rates have many panicked. Interest rates on the 2-year Italian bills rose 150 bps last week, or ½%, as CDS, Credit Default Swaps, jumped 24%. Yields on Spanish, French and Belgian bonds had the highest divergence in euro history versus the bund this past week.

It’s kind of like Greece and Portugal and Ireland have fallen into a pool of quicksand and all the other Euro countries are standing on the side with a rope trying to pull them out of the quicksand, but instead of pulling them out, the strong countries are getting sucked into the quicksand.

Euro area banks and their governments are locked in a potentially fatal embrace. Banks usually own huge quantities of their domestic government bonds.  As a result, any doubts about a country’s solvency quickly infect its banks, making other banks reluctant to lend to them… The amount that banks have been drawing from the E.C.B. has been rising, an indication that many institutions are having trouble raising money on open markets.

Markets swing between greed and fear. Fear is the stronger emotion. And while it might be prudent for an individual investor to sell Europe now and ask questions later, just to be safe without true regard for the facts in each nation, the collective result of all those individual prudent decisions is a staggering negative.

And now the collective actions of the crowd threaten the day-to-day functions of the market – namely the ability to roll over debt at reasonable prices. If the fear in the markets turns into a stampede, the markets could get completely stuck. It’s happened before – remember 2008?

Well, this is not 2008 – it’s probably worse. You’ve got banks in Greece, Spain, Italy, Portugal, Belgium, France, Germany, northern Europe, and Eastern Europe and they are all standing around the quicksand and they are all pulling on the rope – in different directions. And if they start to fall into the quicksand – it is a much bigger problem because the Euro banking system is 325% of the Eurozone GDP, far bigger, relative to the size of the economy than in the US.

A Euro-collapse would be much. Much bigger than the collapse of Lehman brothers, and there are many more moving parts, and more institutions at risk.

So, the Fed has devised a new Stress Test. The idea is that everyone will see that the big US banks are well prepared to handle a Eurozone crisis. The quicksand is over in Euroland and everything in the USA is nifty, peachy kee, and totally copasetic, except that the problems we had back in 2008 were never actually addressed. The US banks are still over-leveraged, still have way too many toxic assets on the books, and nobody knows how many toxic assets they carry on the second set of books, and then there is the little problem of excessive interconnectedness. It turns out the US banks are hitched to the same rope as the Euro banks.

And while the Fed expects the banks to pass the new and improved Stress Test – what if one of the big banks can’t pass the 5% requirement for core tier one equity? Let’s just say, hypothetically of course, that Bank of America  doesn’t meet the standards and they have to raise equity. Now imagine trying to raise equity when all the Euro banks are falling into the quagmire.

And that brings us to the second part of today’s lesson on supply and demand. We’ve already learned what happens when there is too much supply. Now, what do you think happens when the demand dries up?