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Mark's Market Blog

11-25-11: Houston, we have a Rumor

By Mark Lawrence

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Markets dropped again this week on continued concerns about the European banking system. Fear is spreading rapidly through the bond markets about several European countries, now including Germany. France seems in imminent danger of losing their AAA rating, which would definitely be a sign of the apocalypse. Things in Europe are evolving very quickly. I will not be surprised to see major (scary) developments in the next two to six weeks. Germany is dug in, there will be no bailouts in the near future. I believe the Germans have already decided to let things fall apart to improve their bargaining position.

S&P 500 May 19 2011 to November 25,2011

Walmart food prices are rising at a 9% per year rate. The Fed wanted inflation, the Fed gets inflation.

I went to Walmart at 11:20 pm thanksgiving evening. Checkout stands were all closed, waiting to open at midnight precisely. Lines went back at least 100 feet. Everything was already completely picked over: laptops, desktops, TVs, movies, blu-ray players, all gone. I bought nothing. I did note a couple of things: two-thirds of the people in line looked like if someone started screaming "INS!!! INS!!!" they would clear out instantly; and I saw three Latino males in a line, surrounded by kids, no one speaking English, pushing three flats, each flat holding a 65" LED flat screen. It occurred to me that these guys have no plan to get these TVs back to Nicaragua or wherever: they're here to stay.

The Federal Reserve announced Tuesday that it would require the nation's 31 largest banks with assets of $50 billion or more to stress test their portfolios annually against severe economic contraction scenarios in both the U.S. and Europe. In the Fed's first and more extreme scenario, the U.S. falls into extreme recession during the fourth quarter of 2011, contracting some 8%. Unemployment would spike to 13.05%. It's time to get a couple thousand dollars out of your bank, in $20 bills, and keep it somewhere safe. Seriously.

Fed Stress Test Assumptions
QuarterGDPUnemployment10-Year TreasuryDow JonesEU GDP
4Q11-4.84% 9.68%2.07%9,504.48-1.03%

European banks are very short on capital - any external shock and many will require nationalization. The balance sheets of European banks are piled high with legacy assets - mortgages, real-estate, and other loans - that are tying up precious capital and constricting the banks' ability to make new, more productive loans. At the same time, the banks' traditional sources of funding - other banks and institutional investors - have begun drying up as the European crisis intensifies. This leaves the banks desperately needing to raise cash to survive. Their first plan was to sell off the junk assets. Plan A failed when there was a profound lack of buyers. Plan B is Wall Street's old game, securitization. The European banks are packaging up bunches of junk assets, putting pretty bows on the packages, and then using the packages as "collateral" with which to obtain emergency loans from the ECB. Big European banks like SocGen and BNP Paribas have promised to shrink their collective balance sheets by a staggering 5 trillion euros over the next three years. Such a credit shrinkage all but guarantees a massive European recession at the minimum.

A new plan to save Europe is being bandied about. The real fix involves substantial changes to the EU treaty, and would obviously take at least a year to negotiate and ratify. Now people are talking about a bunch of individual bi-lateral treaties involving perhaps as few as 9 of the 27 EU countries. What would these bi-lateral treaties look like? It's not hard to guess. Germans sit in on the other country's budget talks and have some sort of effective veto power, forcing major budget cuts. After the treaties are "negotiated" (you can bet Germany has already drafted them up), then the ECB would be allowed to print. Will it work? For a couple of years, perhaps. In the long run it's clear that Germany and the northern countries cannot share a single currency with the southern countries. But politicians aren't about solutions, they're about quick fixes that last until just past their next election. And meanwhile, we have this great rumor. It's a perfect rumor: it's vague, lacking in all details, and promises free ice-cream and a circus day for all.

Germany tried to sell some government bonds, and their central bank had to step in and buy to complete the auction. German interest rates are now rising. No one thinks Germany is in any danger of going bankrupt. Furthermore, this is only one failed auction, one mustn't read too much into it. However it may indicate that bond buyers are starting to look at the costs to Germany of a Euro breakup.

How are those European interest rates doing? Greece is up, default in the next few months is already priced in. Portugal is rising and their rating has now been lowered to junk, meaning a bunch of banks and mutual funds are no longer allowed to own their bonds. Ireland is stable at 8%. Italy is back over 7%, Spain, Austria and Belgium are rising fast. France is going up, and their AAA rating is now officially in danger. If France loses their AAA rating, this situation will deteriorate quickly. And Germany had a bond auction that didn't go well, now even their rate is starting to rise. Analysts at Nomura bank wrote on Friday "a euro breakup now appears probable rather than possible." United States regulators have been pushing American banks like Citigroup and others to reduce their exposure to the euro zone. Said one French banker, summing up the thinking at French banks, "While in the United States there is clearly a view that Europe can break up, here, we believe Europe must remain as it is." When Intesa Sanpaolo, Italy’s second-largest bank, evaluated different situations in preparation for its 2011-13 strategic plan last March, none were based on the possible breakup of the euro.

European Interest Rates 11-25-2011: Rising to record levels all over.

The situation in Egypt and Syria continue to deteriorate. Libya, Egypt and Syria will most likely be the first countries to meet my criteria for ungovernable. This will spread. Iran goes nuclear, governments all around are falling: this is the Saudi's worst nightmare come to life. Ironically the Saudis may soon find that their best and most stable friend in the region is Israel.

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