The T Report: Curing the Disease Will Alleviate the Symptoms

Weak Economic Data is a Symptom not the Disease

Every day we get a new dumping of bad economic data. Our own data is marginal at best and Europe’s is somewhere between hideous and heinous. But that is a function of the complete uncertainty there.

Europe is grinding to a halt as the threat of redenomination has made trade difficult between countries. Businesses put decisions on hold because they don’t know what currency the deal will get converted to. Individuals are hurt directly by the same issues, and indirectly by companies stagnating.

Europe needs to get everyone on board that no one (at least no one big) is leaving. An exit might be best solution but that is a multi-year process to do correctly. In the meantime they need to ease concerns so that businesses can function and risk of forced currency redenomination is eliminated.

Then sovereigns need to be able to borrow. Not at expensive “market” yields but at the rate the policy makers want (like the U.S. does). Being able to borrow at cheap rates will take “default” risk off the table for now, it will let countries keep current budget deficits small as old bonds are rolled into lower coupon new bonds, and ultimately the secondary market will get dragged along (albeit kicking and screaming).

Then banks need to be recapitalized so that they can lend and not all be stuck in permanent deleveraging mode. Over time they need to deleverage and the worst ones should be put out of their misery, but a functioning credit market is key to any potential turnaround.

If Europe can make real progress on these issues, business confidence will return and economic data will get better. It will get much better in Europe, but would also impact the U.S. and China as the global economy would get some much needed relief from a European turnaround.

Cure the Disease and the Symptoms will go away

So the key is getting currency redenomination off the table. So long as that remains a legitimate concern, businesses won’t take risk. The economies will continue to shrink. But that isn’t a sufficient condition. Governments, banks, and corporations all need access to money at the cheap rates policy makers think is necessary for a turnaround. Setting cheap rates does nothing if people can’t get them. We saw that on a small scale in the U.S. where individuals and small businesses can’t get loans, but in Europe it is the banks, big companies, and even the sovereigns themselves that can’t borrow at the rate targeted by policy makers.

Curing the Disease

Europe cannot be cured overnight, but a lot can be done to treat the disease and bring down some of the symptoms. This is like battlefield triage, take care of the most immediate dangers and then send the wounded back behind the lines where they can be treated more thoroughly.

Steps that would help and are conceivable within existing mandates

• Start the Spanish Bank Bailout. Get money to FROB and get that program started. The markets need to see money spent. The deal may not please everyone, but no deal only pleases the bears and hurts the economy. While the banks are in trouble, the economy is doomed to failure.
• Extend the Spanish Bank Bailout to Italy, and renegotiate deals struck in Greece, Ireland, and Portugal. It is okay to admit the early programs were wrong, when failing to admit it brings much worse consequences
• Focus on the primary market. Spain and Italy need access to money that has maturities of 2 to 5 years with rates of 1% and 2% respectively. The EFSF should provide this as it is pari with other debtholders and is still below the EFSF’s cost of funds. The low coupon ensures that the average coupon paid by these countries decreases over time, making budget targets easier to achieve. The maturity is key as we aren’t constantly rolling the debt. EFSF would likely need even more leverage to make their guarantees work, but that is easy. These are just bond purchases, if worse comes to worse, set up an LCH account and get standard 8 to 10 times margin on Spanish and Italian bonds. Getting leverage on simple bond purchases is easy.
• The ECB should launch a 5 year LTRO. The “carry” trade is better now than in March and the banks that are already “all-in” will probably add, but even banks that still bother with risk management might add if this is in conjunction with the primary market effort above. The LTRO purchases would focus on the secondary market, since the primary plan doesn’t leave much carry. The LTRO already let’s banks use corporate loans, but that needs to be re-emphasized so that corporations can indirectly benefit from new LTRO more than from the previous two.
• The ECB should convert their existing SMP holding in Greece, and possibly in other countries to longer dated, low coupon bonds. This would directly benefit the deficits and cash flows of the countries and send a strong signal that the ECB is willing to be aggressive. The ECB is not a hedge fund, or even really a bank, what does it care if it drops the coupon and extends the maturity? There is no immediate P&L impact, and sure there is less carry over time, but the ECB isn’t really supposed to be making a profit.
• Real progress towards a pan-European banking system where regulations are standardized and enforced the same across all banks. This will take time but could lead to a standardized deposit insurance system. That is less important if they put the other steps into place.
• Finally start the EIB “project” bond program and get some stimulus going.
• Neuter the central banks of each country as it is hard enough to get a consistent ECB message out, let alone one from the ECB and all of their member central banks (bundesbank in particular)

Here is a simple series of steps that could be implemented. The ones in bold are the ones I view as most important and as far as I can tell are just variations of tools they already have that just haven’t been used most efficiently or in a coordinated fashion.

I remain long. Economic data is likely to remain weak, but if anything like the series of steps I mention is implemented, the banks will do very well, and the economies should start to show signs of improvement almost immediately.