Gordon T Long

Gordon T Long

Global Macro Research | Macro-Technical Analysis 

MACRO: REGIONAL

EU

 

AN EU SOVEREIGN BANKING CRISIS II

The Fed rate hikes are toxic for both the Euro and the Yen. The people of both Europe and Japan face losing a great deal of their wealth if the Euro and Yen continue to fall. In the last newsletter, we outlined the de-stabilizing issues facing Japan.
 
The EU however is different in the fact that it has never been stable! I have written since the creation of the EU that it was structurally flawed. I felt that they may be able to form a central bank and common monetary policy (ECB), but you cannot have independent unenforceable sovereign Fiscal Policy and no Treasury bond issuance. It is only a matter of time before the proliferate southern sovereign spenders bring down the system. The EU Energy Crisis may now be the final overdue catalyst!
 
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WHAT YOU NEED TO KNOW
 
  • EURO-ZONE IS A FLAWED CURRENCY & BANKING SYSTEM: The Euro-Zone’s central problem remains a massively flawed currency and banking system.
    • Because many countries and economies share the same currency, when a country fails to keep its budget in-line or falls on hard times, they become a burden to the others forced to carry them. The reality is exacerbated by the fact that roughly 80% of the Euro-Zone’s real economy is financed by a banking sector that is loaded with 600 billion euros in non-performing loans.
    • The EU banks are up to their eyeballs with bad debts and holding worthless paper. Simply put, the whole system is rotten to the core and the Ukraine War and the resulting Energy Crisis may destabilize an already tenuous Euro System!
    • The world’s biggest hedge fund also sniffs trouble. Ray Dalio’s Bridgewater has doubled bets against European banks and other equities over recent days, disclosing short positions worth $10.5B on 28 enterprises.
  • THE RUSSIAN SQUEEZE: The Stoxx 600 has fallen by a quarter since the invasion of Ukraine from what was already a carpet-bombed structural level. This partly reflects fears that Vladimir Putin will cut off gas flows entirely through Nord Stream 1 stopping Europe restocking before winter.
  • A LEHMANESQUE CHAIN REACTION: Germany’s vice-chancellor Robert Habeck is strongly warning that the EU’s energy market is “in danger of collapsing” with the risk of a Lehmanesque chain reaction.
  • MONETARY POLICY GOES “BIZARRE”: The ECB has now announced that it will buy Italian, Spanish, Portuguese and Greek bonds from the proceeds of German, French and Dutch Bond sales to avoid a crash in the peripheral nations. In other words, the ECB will buy worthless bonds with money from maturing viable bonds (those of Germany, France and Netherlands). This is blatant desperation!
  • BAILOUTS BEGINNING: Shares in German gas and power utility Uniper crashed, plunging as much as a fifth on Thursday, after the company slashed its outlook and sought a possible bailout from the German government and after Russia reduced natural gas deliveries to Europe, according to Financial Times. The Economy Ministry confirmed that Berlin and Uniper are discussing “stabilization measures.” Uniper also said talks were underway with the government to secure liquidity, which could include “equity investments” and an increase of a 2 billion euro credit facility with state-owned KfW bank.
 
The EU abandoned all structural reforms in 2014 when the ECB started its quantitative easing program (QE) and expanded the balance sheet to record levels. Making matters worse, the ECB has come up with several schemes over the years to kick-the-can-down-the-road by adding liquidity to this insolvent system.
 
CHART RIGHT: The ECB’s Balance Sheet has grown dramatically from €1.0 Trillion in 2005 to €8.7 Trillion presently.
 
HOUSE OF CARDS!
 
In our April Newsletter entitled: “Credit Leads: The Credit Spigot is Quickly Constricting“, we highlighted the seriousness of the problems within the EU Banking & Financial System. The problems have only gotten worse – much worse!
 
Now the world’s biggest hedge fund sniffs trouble. Ray Dalio’s Bridgewater has doubled bets against European banks and other equities over recent days, disclosing short positions worth $10.5B on 28 enterprises. These include Spain’s Banco Santander and Banco Bilbao Vizcaya Argentaria, Italy’s Intesa Sanpaolo, and France’s BNP Paribas.
 
Bridgewater is also shorting insurers AXA and Allianz, the energy-intensive chemical group BASF, as well as TotalEnergies and the Dutch semiconductor company ASML Holding. The latter two positions suggest that Bridgewater is turning more bearish on the two big trades of post-Covid reopening: European fossil energy and microchips.
 
The Stoxx 600 index of European banks is down by 80pc since peaking in 2007, a casualty of the ECB’s negative interest rates. The sector ought to be recovering as the ECB lines up a string of rapid rate rises over coming months but we suspect it won’t.
 
As the UK’s Ambrose Evans-Pritchard of The Telegraph reports:
 
Oxford professor Richard Werner, a German banking expert, said negative rates have been the kiss of death for Germany’s regional cooperative and savings banks, which specialize in loans to small businesses. The policy has eroded the interest margin of lenders, down to 1.2pc in Europe viz 3.3pc in the US, and undermined the traditional banking model of lending to companies for productive investment. “The ECB has been forcing banks to lend to the property sector in various ways. The only source of profit for them is to fund this dangerous bubble,” he said. 
 
Relief for the banks has been short-lived. The Stoxx 600 has fallen by a quarter since the invasion of Ukraine from what was already a carpet-bombed structural level. This partly reflects fears that Vladimir Putin will cut off gas flows entirely through Nord Stream 1 to stop Europe restocking before winter.
 
Germany’s vice-chancellor Robert Habeck is justified in warning that the EU’s energy market is “in danger of collapsing” with the risk of a Lehmanesque chain reaction. He is right too to warn of serious rationing to come. Pre-emptive demand destruction is the responsible policy.
 
  • What is less responsible is Emmanuel Macron’s decision to extend the cap on gas and electricity prices, suppressing the price signal at great cost to the over-extended French state. He is more or less telling consumers that they can keep wasting energy. It has been left to Total, Engie, and EDF to tell the harsh truth.
  • Above all, the bank slide reflects doom loop fears. We had the first taste of deteriorating debt dynamics two weeks ago when Italy’s 10-year bond yields rocketed to 4pc, a quadrupling of the country’s benchmark borrowing rate since January.
  • Such a move is enough to intrude on assumptions of long-term solvency. “The rise in yields is dramatic and is very clearly a return of the euro crisis,” said Clemens Fuest, president of Germany’s IFO Institute.
  • The risk spread over German Bunds briefly touched 250 points, higher than when Mario Draghi was drafted by the Italian elites to save the country. Such levels recall the revolutionary ferment of the Lega and Beppe Grillo’s Five Star Movement in 2017 – that wild Rome spring later snuffed out quietly the Italian way.
  • “Market rates have already reached a level that, if sustained, could test the sustainability of Italian debt under bearish growth assumptions,” said Silvia Ardagna from Barclays. Debt dynamics “turn dangerous” if trend growth falls below 0.8pc. Good luck with that. Even 0.8pc is well above the average of the last 20 years. 
  • The only way for Italy to avoid a solvency crisis in the long run is through radical reform of the Italian economy. Good luck on that too if the ultra-Right Fratelli d’Italia – leading the polls – take power next year at the head of an anti-system coalition.
 
CHART BELOW: Consensus growth forecasts remain too optimistic for 2022H2 and 2023. Investors are ignoring recession signals at their peril.
 
CHARTS BELOW: Surging inflation refuses easing in soggy Europe…irrespective of how you measure it. The second chart shows the dilemma of “who’s gonna pay” as price increases are becoming harder and harder to pass on to the consumer.
 
 
 
 
AS IN 2012, EU DEBT IS ONCE AGAIN BECOMING UNMANAGEABLE!
 
REMEMBER THE 2012 “PIGS”
– They’re back!
 
EU’S DEBT-to-GDP:
  1. On average, European Union countries had a gross government debt of roughly 88 percent of GDP in 2021.
  2. Italian debt is significant, at 151 percent of GDP. 
  3. Portugal, in third place, had a debt of 127 percent of GDP.
  4. Countries that increased debt between 2020 and 2021 included Germany (up 0.6 percentage points to 69.3 percent of GDP), Romania (up 1.6 percentage points to 48.8 percent of GDP), Bulgaria (up 0.4 percentage points to 25.1 percent of GDP) and the Czech Republic (up 4.2 percentage points to 41.9 percent of GDP).
 
HOW DOES A “TROUBLED” GERMANY CONTINUE TO CARRY THE ENTIRE SYSTEM?
 
  • TARGET2 is the abbreviation of “Trans-European Automated Real-time Gross Settlement Express Transfer System” – a real-time settlement system developed and maintained by the Euro-system. The Euro-system comprises of the European Central Bank and national central banks of 19 member states of the European Union.
  • TARGET2 records claims and liabilities of national central banks, as well as the ECB, against the Euro-system. A country’s TARGET2 balance is affected by its surpluses/deficits in (i) the current account, (ii) the financial account, and/or (iii) the capital account. It is reminiscent of a swap line operation or a change in foreign reserves under a fixed exchange rate arrangement.
 
 
GERMANY IS NOT THE STABLE POWERHOUSE IT ONCE WAS!
 
The German economy is projected to grow by 1.9% in 2022 and 1.7% in 2023, with the recovery hampered by the war in Ukraine and an embargo on Russian oil.
 
Rising inflation is reducing household purchasing power, damping the rebound of private consumption. Investor and consumer confidence have collapsed and supply chain bottlenecks have worsened, postponing the recovery of industrial production and exports towards the end of 2022, despite a large order backlog.
 
In the first quarter of 2022, real GDP grew by 0.2% (at seasonally adjusted quarterly rates). As bad as this is, the outlook has worsened. High inflation and plummeting consumer confidence hurt manufacturing, construction, private investment and exports. The ifo business climate plunged at the end of Q1 by more than 13%. Industrial production and goods exports decreased by 3.9% (and 3.3% M-o-M) in March.
 
Any recovery could be further derailed by a sudden stop of gas imports from Russia or more persistent lock-downs in China.
 
IS THE EU INTENTIONALLY TRYING TO DESTROY ITSELF OR SIMPLY OUT OF ANSWERS?
 
Mish Shedlock recently correctly wrote in “The ECB Has A Huge Dilemma: Price Stability Or Bail Out Nations“. Within a week of Mish writing this, the ECB has announced it will buy Italian, Spanish, Portuguese and Greek bonds from the proceeds of German, French and Dutch Bond sales to avoid a crash in the peripheral nations. This is blatant desperation!
 
 
 
 
 
 
 
 
 
The ECB will pursue bond buying versus selling, broken down by geography.  Reuters reports that the European Central Bank will buy bonds from Italy, Spain, Portugal and Greece with some of the proceeds it receives from maturing German, French and Dutch debt in a bid to cap spreads between their borrowing costs.
 
The Central Bank has divided the euro zone’s 19 countries into three groups – donors, recipients and neutrals – based on the size and speed of a rise in their bond spreads in recent weeks, according to conversations with a half a dozen people at the ECB’s annual forum in Sintra, Portugal. The spreads are gauged against German bonds, which serve as a de-facto benchmark for the single currency area.
 
 
In short, the ECB will buy worthless bonds with money from maturing viable bonds (those of Germany, France and Netherlands).
 
Which, while clearly not QT, at least has a chance of working because as we explained, only explicit bond buying by the ECB will prevent a collapse in Italian bonds. Well, that’s precisely what the ECB is doing, even if it means it can’t claim with a straight face that it is pursuing Quantitative Tightening.
 
The ECB will kick off this “re-balancing” on Friday to prevent financial fragmentation among euro zone countries from getting in the way of its plan to raise interest rates – with an additional scheme due to be unveiled next month.
The lists of donor and recipients countries, which will be reviewed monthly, mirror the division between peripheral (insolvent) and core (solvent) countries that emerged at the time of euro zone’s first debt crisis a decade ago. Recipients include a handful of countries perceived by investors as riskier due to their high public debt or meagre growth, such as Italy, Greece, Spain and Portugal, the sources said.
 
Still, there is a glitch: while redemptions in July and August are substantial, the ECB knows that merely reinvesting of the proceeds will not be enough to calm investors. So the central bank has sped up work on a new tool that will allow it to make new purchases where they are needed if a country meets certain conditions. Needless to say, this is not QT. It is however, QE, and is not just a violation of Europe’s deficit funding limitations, but worse, is a targeted violation, one which will infuriate “donor” nations as soon as the next bond crisis sends core yields soaring while keeping Italian spreads artificially low.
 
The ECB’s new tool may be ascertained by the European Commission, based on its fiscal rules or economic recommendations, or by the ECB itself via a debt-sustainability assessment, as it did with Greece a few years ago, sources have told Reuters. The former option would keep the ECB above the fray but make it dependent on another institution. The latter would give central bankers a greater say but open them to accusations of getting involved in politics. The ECB may then drain cash from the banking system to offset its bond purchases, most likely via special auctions at which banks can secure more favorable interest rates if they park funds at the central bank. Read more
Policymakers have yet to decide whether to announce the size of the scheme, as they hope its mere announcement will stabilize markets and they may not have to use it.
 
 

 

 

 

 
 
EUROPEAN CREDIT PROTECTION IS SKY HIGH!!
 
HERE ARE THE CORE ISSUES FACING THE EU
 
  • EU leaders never delivered on plans agreed in 2012 for a full banking union. They never tackled the “doom loop”, that lethal and particular Economic and Monetary Union pathology in which sovereign states and commercial banks pull each other down in a self-feeding spiral. 
  • They kicked the issue into touch once the European Central Bank started monetizing everything, which masked the problem and sent the doom loop into remission. But the threat remains. That is suddenly front and center again as inflation forces the ECB to halt purchases of Club Med bonds, and therefore to halt its covert bail-out of Italy and Spain.
  • “Club Med” (in 2012 we called them the PIGS) public debt is higher today as a share of GDP than before the last episode of the doom loop in 2011-2012. The ratios have jumped from 120pc to 151pc in Italy, 69pc to 118pc in Spain, and 109pc to 127pc in Portugal. In France, a borderline case, it is up from 87pc to 113pc.
  • Debt service costs have fallen and maturities are longer. Italy’s interest payments have dropped to 3.3 of GDP from 4.5pc 15 years ago. But markets know that the era of free money is over and they have a habit of pulling forward changes in trajectory.
  • Lorenzo Codogno, chief economist at the Italian treasury during the last blow-up and now at LC Macro, said there are “disturbing similarities” with stresses before the dam burst in 2011. On that occasion it was monetary tightening by the ECB – two catastrophically ill-timed rate rises into the teeth of a European recession. This time it is the double punch of ECB rates rises and the end of QE, forced upon the governing council by 8.1pc inflation and by the rising fury of Germany. This is colliding with Putin’s energy crisis. Mr Codogno said markets are likely to test the ECB’s policy of “constructive ambiguity” on backstop measures for Italian debt. While the Italian banks are better capitalized than a decade ago – and bad loans are back to pre-Lehman ratios – these lenders have nevertheless just suffered a wicked haircut on their Italian bonds.
  • It is not clear how many have unmatched liabilities that must eventually be marked to market, eating into their capital ratios. This in turn forces them to curb credit, worsening the recessionary effect in a vicious circle.
  • A perverse side-effect of ECB bond purchases is that foreign investors were able to offload Club Med debt at a profit. Italian, Spanish, Portuguese banks more or less did the opposite. They borrowed for free from the ECB to buy bonds issued by their own government, enjoying a risk-free rent from the spread on the carry trade. Prof Werner says absurd Basel banking regulations encouraged them to do so.
 
THE BEGINNING OF CORPORATE BAILOUTS BY BANKRUPT EU SOVEREIGNS!
 
 
Shares in German gas and power utility Uniper crashed, plunging as much as a fifth on Thursday after the company slashed its outlook and sought a possible bailout from the German government after Russia reduced natural gas deliveries to Europe, according to Financial Times. 
 
Uniper said earnings before interest and taxes would be “significantly below” previous years, considering it only received 40% of the NatGas from Russia’s Gazprom PJSC.
 
The recent decline in NatGas flows to Europe forced Gazprom’s largest customer into covering purchases in spot markets at a massive premium versus its long-term NatGas contracts. At the same time, Berlin has capped the prices it charges households and businesses to control inflation, resulting in the utility losing tens of millions of euros a day (RBC and Citigroup analysts estimate the utility is losing 30 million euros per day) — and the risk of the utility company imploding. 
 
Bloomberg’s Javier Blas said Uniper’s NatGas losses could be a staggering 11 billion euros on a yearly basis if it has to continue buying on the spot market. He then pointed out that contagion risks could be emerging as other utilities are likely doing the same. 
 
“Uniper currently procures substitution volumes at significantly higher prices,” Uniper said Wednesday, adding that since it “cannot yet pass on these additional costs, this results in significant financial burdens.”
 
The Economy Ministry confirmed that Berlin and Uniper are discussing “stabilization measures.” Uniper also said talks were underway with the government to secure liquidity which could include “equity investments” and an increase of a 2 billion euro credit facility with state-owned KfW bank. 
 
News that Uniper is in dire straits sent shares down as much as 23% to five-year lows. 
 
German Economy Minister Robert Habeck recently warned that declining NatGas from Russia could trigger a Lehman Brothers-like moment. 
 
Since mid-June, Gazprom reduced NatGas deliveries through Nord Stream to Europe by 40% and blamed the decline on Canadian sanctions over the war in Ukraine, preventing German partner Siemens Energy from delivering critical overhauled equipment for a compressor station on the pipeline. The crunch is also impacting France, Italy, and Austria as NatGas prices have jumped more than 40% in the past two weeks. 
 
John Musk, an analyst at RBC Europe Ltd., said the focus would be on contagion and if “other utilities with gas supply exposure” will be affected by the supply crunch. 
 
The situation may worsen when Nord Stream halts Nord Stream flows for ten days in July for planned maintenance. There are mounting concerns Russia might not resume the pipeline to full capacity after the outage. 
 
Habeck said last week Germany should prepare for further cuts. Europe’s largest economy has declared the second “alarm stage” of its NatGas-emergency plan, allowing utility companies to pass on higher power prices to industry and households to curb demand. 
 
“Europe should be ready in case Russian gas is completely cut off,” IEA head Fatih Birol told FT News last week.

 

 

 

 

 
 
 
 
 
CONCLUSION
 
As the UK’s Ambrose Evans-Pritchard of The Telegraph concludes:
 
The ECB is trying to conjure up a new (non-inflationary) debt shield to replace QE. Markets are skeptical. This so-called anti-fragmentation mechanism has yet to see the light of day, probably because the northern governors insist on ferocious conditions.
 
Even the cleverest EU lawyers have yet to find ways to reconcile a pure bailout instrument with the no-bailout clause of the Maastricht Treaty, and therefore to find a way to head off a fight in the German constitutional court.
 
The EU has not resolved the fundamental incompatibility between two halves of the euro-zone that should not be trying to share a currency. The contours have changed over the last cycle but the gap remains as wide as ever.
 
Europe’s leaders and authorities – above all Germany’s political class – will do what they always do when trouble arrives. They will prevaricate until matters become perilous. They will then do the minimum necessary to hold the structure together. German judges will let it pass whatever the law says. The alternative is to let monetary union disintegrate, and that is too awful to contemplate.
 
So yes, European bank stocks are cheap. They are cheap for a reason!
 
 
ADDENDUM – Latest Report
 
  • CHART 1: “Two weeks ago, Russia reduced Nordstream gas flows by 60% on the back of an alleged disruption over Siemens part supplies.
  • CHART 2: While the immediate availability of gas in Germany is not an issue, the energy market is starting to price a risk of a complete disruption to gas supplies for winter, and year-ahead natural gas prices are making fresh record highs.
  • CHART 3: Most concerning however, is the skyrocketing price of electricity. Prices for 2023 delivery have also soared to all-time highs and have now tripled from the start of the year. French and Italian electricity prices are similarly soaring.
  • CHART 4: Which brings us to the above mentioned collapse in the share price of Germany’s largest utility gas consumer, which just dropped to record lows amid speculation of an imminent bailout.
 
As the DB strategist admits, his underlying assumption this year was that gas supplies to Europe would continue: even though the Nordstream pipeline is set to shut for ten days during July 11-21 for regular maintenance. Press reports suggest that authorities are attempting to find a solution on sanctions restrictions to move gas turbine components back to Russia. Yet the German government is stating that disruptions are politically motivated and there are risks supply may be completely shut off.
 
So, as Saravelos warns, if the gas shutoff is not resolved in coming weeks, this would lead to a broadening out of energy disruption with material upfront effects on economic growth, and of course much higher inflation, or as he puts it, “beyond the market’s worries about slower global growth in recent months, what is unfolding in Europe in recent days is a fresh big negative supply shock.”
 
If so, it would clearly make the ECB’s job more difficult and their reaction function ambivalent. But as far as the EUR/USD exchange rate goes, it would provide clear downside, as not only would the energy import bill rise due to even higher prices, but it would raise the risk of an imminent German recession on the back of energy rationing. So while DB’s EUR/USD forecasts imply a range-bound euro over the summer months, the bank’s chief FX strategist is worried that the energy situation is providing clear downside risks.
 
As for July 22, or a Friday three weeks from today, fellow DB strategist Jim Reid asks whether this could be the most important day of the year: “while we all spend most of our market time thinking about the Fed and a recession, I suspect what happens to Russian gas in H2 is potentially an even bigger story. Of course by July 22nd, parts may have be found and the supply might start to normalize. Anyone who tells you they know what is going to happen here is guessing but as minimum it should be a huge focal point for everyone in markets.”

 

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