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Credit contraction continues in Europe

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th-928-tumb(Sept. 28, 2009 - Erwan Mahe) As you all know, I really hate to step on the toes of the guardians of the temple, Mr Weber and Mr Stark, who continuously reassure us that there is no risk of a credit crunch or deflation on the eurozone.

However, these twin dangers continue to rear their ugly heads, despite the clairvoyance of the ECB and its economic staff (headed by none other that Mr Stark) in economic forecasting (Thaler’s 16-10- 08: The Brüninguian obsession).

We warned last week that M3 money supply figures on the eurozone could be lower than expected. As it turns out, the August publication shows M3 growth of +2.5% on an annual basis, vs consensus expectations of +2.7%, and +3% growth in July.

As such, M3 growth for the year is +2.3%, which is unprecedented since this statistic began publication in Europe. As you can see in the graph below, this indicator was growing by over 12% at year-end 2007!

I added on this graph the CPI published this morning for the Hesse region of Germany, -0.8% on an annual basis, which is as much below the ECB’s target range of a bit less than 2% as M3 is below its target zone of +4.5% YoY.

One of the most striking points of these money supply components is that the growth in loans to households has gone into negative territory, at -0.2% on an annual basis. One more precedent on the eurozone!

This is one of the absolutely logical consequences of today’s debt deflation process, for which we still do not see an end. It is as much the result of bank de-leveraging, as it is the strong reluctance of households to increase debt when real interest rates are so high and unemployment continues to rise.

In any case, eurozone officials must end their contradictory policies whereby they tell commercial banks to inject the funds they have received from the central bank (1-year LTRO today) while telling them to strengthen their balance sheets by reducing their leverage!

In fact, officials would like the concerned banks to carry out hard capital increases (no hybrid shares) so that existing shareholders participate via their dilution in efforts carried out in recent months by the ECB (low interest rate and QE) and governments (deficit spending and bank support).

This shift is already apparent in other countries, like the UK and Sweden.

Returning to the CPI, we remain convinced that, even accounting for the fact that the base effect from last summer’s spike in commodity prices will soon be dissipate, the contraction in credit and the ECB’s vigilance will counter any rebound in prices indices above the ECB’s comfort range.

This is a good thing for the area’s economy because it guarantees that interest rates will remain low for a longer time period than the consensus is willing to recognise. Moreover, we find the December 2010 Euribor contract at below 98.20 (1.80% rate) still too cheap.

But this European virtue, in the “Austrian” sense of money quality, entails serious dangers.

First, it leads to the euro’s continuous appreciation against the dollar and pounding sterling, given the perceived need to diversify international bond (and sovereign) portfolios for fear of a strong anti-inflation drive by US and UK central banks.

This implies a surge in deflation within the eurozone!

The Swiss have come to understand this danger, given their intervention to prevent their currency from appreciation, while ECB officials are beginning to come around, with Mr Trichet’s comment yesterday to Corriere della Serra:

“Assurances by senior U.S. officials that they desire a strong dollar is very important for the stability of exchange rates and the prosperity of the global economy “.

On the other hand, he must be the last one to believe in these assurances, given our American neighbour’s long history of benign neglect on the matter, like when former Treasury Secretary under Richard Nixon, John Connally, ended the dollar’s convertibility to gold on 15 August 1971:

"The dollar is our currency and your problem"

The greenback lost half its value against the deutsche mark between 1972 and 1979, after which Mr Volcker put an end to the party, hiking interest rates to 19%.

This means that the euro could rise to $2, which really takes the cake, given the state of the European economy, and the fact that yuan continues to be pegged to the greenback.

This would be the best way for the eurozone to also experience Japanese-style lost decades. We cannot emphasise enough how difficult it is to pullout of such a deflationary spiral once trapped within it.

M3 and loans to eurozone households, CPI Hesse

No let up in debt deflation!


Japan published yesterday evening its corporate price index and -- Surprise! Surprise! -- it dropped by a record 3.5% on an annual basis.

As such, keep a close eye on Japanese CPI, out this at 1:30 am at around -2.2%...

New Finance Minister, Mr Fuji, who had earlier declared that he was not overly concerned about the yen’s current strength, will soon have to put a little water in his saki if the Japanese currency begins hovering around 85 Y/$.

For those who are counting on a rebound on the US real estate market to reverse world macroeconomic trends (that’s right, I know plenty of them), you might want to meditate on some statistics published last Friday:

The average price of new homes has fallen to $195,200, i.e. the level of October 2003, down by 9.5% m-o-m, the sharpest decline since 1963 when this statistic began publication!

How is the US real estate market supposed to turnaround, given the weight of price competition from homes sales orchestrated by financial establishments, following the wave of foreclosures (still in the works), especially since the subsidies to help first-time buyers will end at 31 December 2009?

It is also worth noting that the latest IPOs in Hong Kong and Chinese ones in New York do not at all present the same bullish traits as in past months, like the ADR of Shanda, down 14%, and or like in commodities with the Baltic Dry Index (-50% since the beginning of June). It would appear that markets are beginning to realise that the build-up of Chinese reserves is finally coming to an end.

In such a context, we prefer to maintain our asset allocation biases:

- Favorable to fixed interest rate instruments, with a now more favorable bias to the 5-10 year range, helped by the expiry of digital currency options (as part of the PRDC: Power Reverse Dual Currency Notes) on the dollar-yen (our IBs of last week) which led to a flattening of the yield curve in the US and Europe.

- On stock markets, we have returned to a negative bias after hitting our target range of 2850-2900 on the Eurostoxx, with, for example, the October put ladders. We did not advise an overly aggressive hedge strategy because the fact that indices rebound after each plunge highlights the persistent desire to invest of laggards frustrated by 0% interest rates.

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