Thoughts on a “too quiet” Labor Day

The stock market is closed today for Labor Day.

A few thoughts on the preceding week:

1)   The US Federal Reserve disappointed in a big way during its annual Jackson Hole meeting. It was in 2010 that Fed Chairman Ben Bernanke hinted at QE 2, which kicked off a large rally in stocks and other risk-on assets.

Investors and the mainstream financial media are desperate to claim he did something similar this time around. He did not. Instead, he issued the same message the Fed has issued for over a year: we stand ready to act if things get bad.

However, this has not stopped the media from proclaiming that the Fed has left the door wide open for announcements of QE at its September 12-13 FOMC meeting. This however is virtually impossible due to a) food prices, b) gas prices, c) the upcoming US Presidential election election and d) the fact that the banks don’t need QE, they already have ample liquidity sitting around (this is a solvency crisis, not a liquidity one).

2)   The Euro and Euro stocks have lead a tremendous rally ever since the European Central Bank President Mario Draghi promised the ECB would take major action that would prove sufficient to stop the crisis. Saner minds have been asking, what specifically has Draghi accomplished?

From a banking capital basis, the answer is nothing. EU banks remain under capitalized and over leveraged. No new capital has been created.

From a bailout mechanism perspective the answer is again nothing. The EFSF bailout fund has roughly €65 billion in firepower left while the ESM doesn’t even exist yet (and won’t until Germany rules it constitutional on September 12… a development that is not guaranteed).

From a political perspective Draghi once again has accomplished nothing. Germany, which remains the real de facto backstop for the EU, remains opposed to more bailouts. Meanwhile Spain and Greece are back at the bailout trough demanding more funds or more time. And of course, Italy remains in the side-wings ready to take center stage in the coming weeks.

So… no new money, no new funds, and no change in the political landscape. Draghi has obviously learned the power of verbal intervention (the US Fed’s primary tool over the last year)… How long can he use this tool successfully remains to be seen.

Oh, and France just nationalized its second largest mortgage lender. But don’t worry, the EU Crisis is definitely contained and Draghi and others have got everything under control. After all, when the US nationalized Fannie Mae and Freddie Mac in 2008 the financial crisis came to a screeching halt… didn’t it?

3)   I continue to receive email after email assuring me that the Central Banks are capable of hitting print and saving the day. My answer to these messages from a purely logical standpoint is: if that were the case, they would have done it by now.

From a more analytical standpoint, we have to consider that this is a solvency crisis. You cannot solve a solvency crisis via more debt.  Nor does liquidity solve anything major: liquidity only helps in day to day funding which banks need when they are truly on the brink of collapse a la 2008.

So, printing doesn’t help or change anything.

But what about debt monetization? Surely the Central Banks can print money and then use this money to buy bonds much as the Fed did with QE 1 and 2?

Again, this argument doesn’t add up. There is a reason that French, US, and German bonds are yielding so little right now. That reason is that the global financial system is starved for quality collateral: sovereign bonds remain the senior most assets/ trading collateral for the major banks.

QE or printing money to buy bonds actually removes collateral from the financial system. It may be helpful in terms of short-term funding for banks and nations that are truly on the brink of collapse and whose collateral is garbage anyway (Spain and the other PIIGS), but this “help” is much like a shot of adrenaline for a patient who is on the verge of death.

But why can’t cash be used as collateral much like sovereign bonds?

Because the global banking system is based on sovereign bonds, not cash. Look at any bank’s balance sheet and the senior most items are “cash and cash equivalents.”  Read the notes on this “asset” and you’ll see that it’s actually “highly liquid sovereign bonds.”

True, banks use actual cash for day-to-day funding. But when it comes to building their trading portfolios (where much of the profits are made) it’s sovereign bonds backstopping the whole mess. And banks have built some truly insane trading portfolios: the global derivatives market is over $700 TRILLION in size.

This is why the ECB keeps letting banks pledge their sovereign bonds as collateral for cash, only to then give them more sovereign bonds which they can then pledge as more collateral to get more money, rather than the other way around. By the way, the same tactic is being used in the UK and elsewhere.

To return to an earlier point: this is why French, German, and US sovereign bonds are yielding so little: they are considered the least risky of the sovereign bond market and therefore are the best collateral.

Consequently, banks are piling into these bonds, pushing the prices up to the point of little or no yield (the US) or even negative yield (recently France and Germany).

It’s also why everyone was so clear that Greece didn’t actually “default” during the second bailout. And it explains why the ECB and others are doing everything they can to stop any EU sovereign nation from defaulting: because doing so means the collateral for hundreds of billions of Euros worth of trades going up in smoke… and down go the EU banks and the EU banking system.

A question for you on this Labor Day when you’re enjoying a cook-out or playing with your kids… how can the Central Banks fix this mess?

On that note, I’ve already alerted my Private Wealth Advisory subscribers to a handful of investments that will explode higher as the markets realize the obvious truth: the Central Banks are tapped out for now.

To find out what they are… and start receiving my bi-weekly investment research reports including real time “buy and sell” alerts via email, you need to take out a subscription to Private Wealth Advisory. To do so…

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Graham Summers

Posted by Phoenix Capital Research