by Cliff Wachtel, Global Markets
Lessons last week’s market action taught for this week- Part 1
Here’s what we learned from the prior week’s market activity. The idea is to provide a quick summary of the top market drivers each day on all three continents, and then derive whatever useful conclusions we can for the coming week and beyond. I do this because I need it and no one else does it.
First, here’s a quick wrap up of what happened and what caused it each day in all three regions.
Monday: Early Rally On Cyprus Deal Reversed By Dijesselbloem Remarks
Asian indexes closed mixed mostly higher, Japan (1.69) and Honk Kong (0.61) strongly higher on news of a deal between Cyprus and the EU. The key point was that the deal left insured deposits untouched, and thus dodged the dangerous precedent of violating the protection of EU deposit insurance. That risked undermining confidence in the safety of EU bank deposits, particularly in GIIPS nations, and encouraging bank runs that could start a new and potentially fatal chapter in the EU crisis.
While much detail was missing, it was clear that deposits of over the 100,000 euro limit of EU deposit insurance at the two largest banks would bear the full burden, and that there would be at least some temporary capital controls. Those controls had some correctly realizing that Cyprus while these remained in effect Cyprus was in reality out of the Euro-zone because a Euro in a Cyprus bank wasn’t as liquid, and thus worth as much, as a Euro elsewhere in the EZ.
EU solidly lower about 0.6% typically after a strong early rally that fell apart as euphoria about the new EU-Cyprus bank bailout deal collapsed. The cause of that breakdown was Euro group’s Jeroen Dijsselbloem’s excessively honest comments that the bailout deal would be a template for Euro zone bank rescues. These words re-ignited fears about the safety and liquidity of bank deposits, and thus of bank runs, in the EU, especially in the EU’s soft spot – GIIPS nations’ banks. It was bad enough if he was referring to “bail-ins” by uninsured depositors, but even worse if he was referring to capital controls and border checks.
He and the rest of EU officialdom quickly began backtracking on that statement. European indexes would spend the rest of the week trying (unsuccessfully) to recover from concerns about EU bank deposit safety. See the Conclusions and Lessons section below for more on that.
As the week progressed, it became clear that capital controls were indeed part of the deal. How long they’ll be in place is unknown, probably for as long as Cyprus sees a threat of bank runs. That could be a long time, because it’s hard to see why any foreign depositor would want to keep funds in Cyprus anymore.
US indexes closed moderately lower, about 0.35%, and in fact recovered from deeper losses after Dijsselbloem attempted to revise his earlier statement on how the Cyprus bailout was a template for future EU bank failure resolutions. Also helping US stocks was NY Fed’s Dudley saying the US must continue with stimulus because of the weak jobs market.
Tuesday: Markets Rise By Focusing On Good US Data, Ignoring The Bad, Stimulus Hopes Support Japan
Asian indexes closed mixed mostly lower on continued worry that the Cyprus deal could yet cause contagion because of its precedent setting losses to uninsured depositors and capital controls. Losses were capped in Japan and those related to it by (what else?) hope for more stimulus being announced at next week’s BOJ meeting. New Governor Haruhiko Kuroda reiterated the BOJ’s determination to expand its balance sheet more aggressively in order to stop deflation, and push down bond yields of all maturities via purchasing longer dated (as well as the more customary short term) Japanese government bonds.
European indexes were mostly solidly higher, over 0.5%, as investors focused on better than expected US durable goods and house price data, and ignored much worse than expected consumer confidence and manufacturing data, and also shrugged off the worries about Cyprus-inspired GIIPS banks runs and Italy’s continued inability to form a new ruling coalition.
US indexes were also solidly higher as the DJIA hit a new high and the S&P 500 closed a mere 2 points below its all time high as traders followed Europe’s cue of focusing on the good US data and ignoring both the bad data as well as the mess in Cyprus and Italy.
Wednesday: Asia Up On Follow Through From US, Europe And US Down On Italy, Cyprus, UK Concerns
Asian markets closed higher on good US data for home prices and durable goods.
European indexes were down hard, around 1%, on concerns about unresolved long term political instability in Italy, contagion risks from the evolving Cyprus crisis, and downbeat Bank of England comments on the massive risks to UK banks and thus the need to raise their capital requirements.
The plunge also hit the EURUSD, sending it to fresh monthly lows, breaking near term support and ultimately heading lower to test deeper support
US markets closed mixed with overall only minor pullbacks as an down opening was used as buying opportunity, for all the same reasons that have kept US markets rising towards historic highs despite bad data from most of the developed world, a US economy still nowhere near 2007 levels, and declining earnings (stimulus and…anything else besides hopes for more stimulus?). Optimistic comments from two dovish Fed Presidents also helped. See our Conclusions and Lessons section below for an important lesson from Fed President Evans.
Thursday: Asia Mixed On Follow Through From US, Europe, US Both Up On Smooth Cyprus Bank Opening, Focus On Positives In German Data
Asian indexes were mixed, with Japanese indexes down hard on Italy’s rising borrowing costs and how Cyprus bank re-openings will go. Chinese indexes were down harder on worries over new restrictions on the property sales and China’s infamous wealth management products, which are part of an unregulated and opaque shadow banking industry.
European indexes ended higher due to a smooth bank re-opening in Cyprus, despite mixed data from Germany showing better than expected retail sales but a worse than expected unemployment change.
US indexes closed solidly higher as a combination of momentum and follow through from Europe helped push indexes higher and the S&P 500 to a new all time high of 1568. US economic reports were bad, with both first time jobless claims and Chicago PMI worse than expected.
Who needs fundamentals like economic and earnings growth when you’ve got plenty of stimulus and most other markets look worse?
For the US, Europe, and much of Asia, Thursday was the end of a shortened trading week due to Good Friday.
Friday: Most Markets Closed For Good Friday
With so many markets closed the day had little significance.
Of the Asian indexes that were still open, the Nikkei, Kospi, and Shanghai indexes were all up about 0.5% on combination of Asian fiscal year end window dressing purchasing, upbeat mood after the new S&P 500 all time high of the prior day, capped by some profit taking on caution ahead of a busy week ahead that includes 3 major central bank rate statements and US monthly jobs reports.
European and US stock markets were closed for good Friday. Forex markets were open, but trade was quiet.
Lessons from last week’s market action for this week- Part 2
Following up from part 1, here are the conclusions and lessons gleaned from last week’s market action for the coming week and beyond.
Conclusions And Lessons: Cyprus, Importance Of Coming Week
First, here’s an update on the confiscations of deposits at Cyprus’s biggest bank, the Bank of Cyprus. Early in the week it appeared that deposits over 100k Euros would take a 30% hit. Later in the week we started hearing 40%. As of Saturday, it was reported that the official decree would give depositors shares worth just 37.5% deposits over 100k Euros, assuming those shares can actually be sold at the issue price. So at best those deposits over 100k Euros face a 62.5% hit. It could get worse if the shares lose value or if there are restrictions on selling the shares.
Depositors with sums of over 100k Euros at the second largest Bank, Laiki, have nothing to fear. They’ve already lost everything over the EU insured 100k.
There have been no changes to the controls on cash and credit card withdrawals announced earlier in the week.
Winners And Losers
- Continued Contraction, Bad Data: While German data shows it’s economy is still holding on, the rest of Europe looks awful overall, and the only debate over the GIIPS is whether or not they’re already in a depression on the scale of that seen in the 1930s. See here for a sample of the articles this past week on that theme.
- Italy And Cyprus: The two big EU concerns of recent weeks both appeared to be hitting their worst case scenarios.
Obviously Cyprus was THE big loser. See below for all the gory details.
Italy couldn’t form a government, which means months of lingering political uncertainty and probably new elections within the year to replace the temporary caretaker government appointed by the President.
The big ramification is that the EU could be pressured by heightened political uncertainty for much of the remainder of the year at a time when it desperately needs the opposite in order to maintain confidence in the face of the continued contraction noted above.
Germany also has elections later this year and the existence elections in both the major creditor and debtor nations’ risks pushing both polities to opposite extremes as candidates in both elections play to voter fears about the other nation.
Markets were stressed by fears of increased regulations to cool property prices and sales of opaque but profitable “wealth management” investment products.
The US, as much by default as anything else, as its indexes continue higher and its economy continues to slowly improve under continued stimulus. The US isn’t as bound to the decaying EU as Germany, it isn’t a demographic disaster like Japan, and it isn’t in a tightening process like China. No wonder money continues to pour into US stocks as investors accept higher P/Es, and the S&P 500 was finally able to break to new highs despite declining earnings growth.
Seven Big Cyprus Ramifications
Oof. Where do we even begin? So much has already been written, not without justification. This was big. For the first time since the Greek bond haircuts (which hit Cyprus banks and arguably were a key driver of the Cyprus mess) real pain was inflicted on investors rather than taxpayers. That brings contagion risks, as we discuss below. Here are the key ramifications thus far.
1. Defined The Template For EU Bank Bailouts: Systemic Risk The Key
Markets freaked on Monday at the suggestion that the Cyprus bailout was indeed a precedent for confiscating deposits and capital controls in future EU bank bailouts. The implication was heighted risk of massive bank run on GIIPS banks and end of the EU.
Of all the articles I read that attempted to define the how the Cyprus deal had increased contagion risk, The Telegraph’s Jeremy Warner hit it best. In essence, he wrote that deposit safety correlated directly with how much of a systemic risk a given bank presented. That risk was defined by both the size of the bank and its sovereign state. He likened the situation to that of the US, where depositors at small local banks lose everything when federal authorities close them down, but those at big banks with huge corporate depositors and international presence (aka TBTF banks) get bailed out because they would take down their big corporate and sovereign depositors with them. See here for details.
2. Cyprus’s Future: Depression, EU Exit
Despite all the pain, it’s very unclear whether Cyprus will avoid the death spiral and probable EZ exit occurring in Greece.
- The deal killed off Cyprus’ main industry and best paying employer, its offshore banking industry.
- The deal still leaves it with over 140% debt/GDP, which most economists do not believe is sustainable under any circumstances. Cyprus’ economy just lost its biggest driver, offshore banking, so chances of recovery are virtually nil.
3. Cyprus Capital Controls Mean De Facto EUR Expulsion
If a Cyprus Euro isn’t as liquid as any other, it isn’t worth as much and thus Cyprus is no longer a full EZ member. No doubt depositors in banks of other at risk nations will take note, and those with over 100k Euros on deposit at any one bank will be far more inclined to take these funds elsewhere while they still can.
Thus far, these include:
- Withdrawal limits of 300 Euros
- Maximum transfers of 5000 Euros
- Restrictions on credit card use
- Limits of 1000 Euros that can be taken abroad
4. Contagion Risk Up
This is the biggest lesson of the prior week, and its effects could be felt for months or years to come.
The Cyprus deal dispensed with any doubt that EU bank deposits (as well as those in the US and UK) are less safe than previously believed, especially those in the GIIPS nations’ banks. A lot was written about that last week. See here, here for examples of the genre. Key points include:
- Bank Runs, Long Term Capital Flight More Likely: For bailed out nations, depositor contributions to bailouts and capital controls (which effectively make Euros in these banks less liquid and thus less valuable. In other words, a nation can be stuck with a second class Euro and subject to a light form of EU expulsion. That risk will now weigh on depositors of all GIIPS banks and make them quicker to flee in the future. Why would anyone keep deposits in GIIPS banks unless it was absolutely necessary? Even insured depositors can see their access cut for an indefinite period, as the Cyprus deal demonstrated.
- Future Bailouts Harsher: It’s become politically suicidal for funding nation leaders to bail out debtor nations without squeezing maximum cash out of these countries first.
- Borrowing Costs Up For GIIPS Banks: Unlike Cyprus, the other GIIPS nations have bondholders who can take losses before depositors, so it’s going to be harder for GIIPS banks to get interbank credit needed for daily operations. In other words, these challenged banks now have another challenge to overcome.
To be completely fair, there are those who insist that while EU depositors are now on the bail-in menu, the protection of insured depositors has definitely been confirmed. We disagree. EU leaders (and initially Cypriot politicians too) were ok with hitting insured depositors. It was popular opposition in Cyprus that prevented this move.
The last time private investors (i.e. the ones that rule the markets) rather the taxpayers had to take this kind of pain was the Greek bond haircut in the summer of 2011, which led to spiking borrowing costs in Spain and Italy.
Risks of new crises in Spain and Italy are trending higher along with their bond yields, and markets are focusing on Slovenia as a likely next hot spot. See our article on the top market drivers for the coming week here for more on that.
5. Continued EU Anxiety Means Continued EUR Downtrend, USD Uptrend In Months Ahead
All of the above serve to remind us all of just how big a mess the EU really is, and that’s brought a new batch of articles predicting the EU’s demise. Here’s the best I saw last week.
European stocks have been flat-to-lower in recent weeks, but the EURUSD and other EUR pairs have been sliding hard since the start of February. Barring assorted short term counter moves, this longer term trend, in place since early 2011, should remain in place, and provide some support for the USD and USD investments.
6. Contagion Risk Beyond The EU?
The Cyprus deal raises questions about deposit safety even outside of the EU, and that produced some interesting commentary last week. Quick, which investment is more senior in the event of a bank failure, a savings account or derivatives counterparties? See here for the answer. This article has held on for 3 days at the very top of seekingalpha.com’s top article list as of this writing. That only happens when an article really hits a nerve.
7. Harsher Bailouts Until After German Elections
German voters have not been kind to the ruling coalition in recent years, and that’s believed to be due to anger at seeing their money loaned or given to GIIPS nations of dubious creditworthiness. Much was written last week about how German PM Merkel was the big winner from the Cyprus deal. As Wolfgang Munchau wrote (via businessinsider.com here)
There are so many reasons why Cyprus was a win for Merkel:
- She got to show her tightfistedness (even though we were never talking about much money).
- She helped insure a diminished future for the Cypriot banking system.
- She stuck it to the Russians.
- She did it all while creating virtually no financial contagion/ripple effects elsewhere in Europe.
- She showed that there’s no serious opposition to Germany among the rest of the nations.
Next Week Is Big
The first week of the month is usually busy, and the above makes it even more important.
It’s packed with top tier EU PMI reports, bond auctions of benchmark 10 year bonds, and more. See our article on coming week market movers for more.
Fed President Evans: Watch US Jobs Reports Next Week – Closely
Last week Chicago Federal Reserve Bank Charles Evans noted that he wanted to see 6 consecutive month of over 200k job growth before he’d support any reduction of QE 3. Bernanke probably feels the same way.
QE 3 is the primary driver of the US stock rally in the face of data and earnings that don’t support the current historical high or high levels in stocks, US farmland, and other risk assets.
US jobs reports (ok, retail sales and GDP also important) are the biggest single driver of the decision for when to pare back QE 3, and probably these same asset prices.
The last three months showed 155k, 157k, and most recently 236k for February.
Markets are forward looking, so it will be interesting to see how many months in advance risk asset markets will start pricing in QE 3 withdrawal, and whether it makes investors feel optimistic enough to continue the rally or if it causes a selloff.
Thus far the consensus estimate for Friday’s NFP is just around 200k. A second straight 200k month makes it two out of six.
See our article on the coming week’s top market movers for details.
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