Recap 3-27-13: The Fat Tail

Commentary:

I’ve been considering two different interpretations of the Cyprus events. There is a possibility that these views both become consensus views, although at different times. Allow me to elaborate.

The Bearish View:

This appears to be the current consensus view. There is outrage that the EU has broken both precedent and laws that puts depositor funds at the very top of the capital structure. As a result, depositors in the rest of the Eurozone should now be very worried about whether they will be party to future bank ‘bail-ins.’ Since banks in the peripheral countries are the least capitalized, this implies a strong risk of bank runs all over the periphery. And bank runs, as we all know by now, can get out of control very quickly. This view holds that EU policy makers are retarded, and that the risk of EU-wide bank runs could causes a sharp and possibly catastrophic stop in credit conditions.

The Sanguine View:

There is a method to the madness. The other main EU countries are actually fairly united, but are happy to let the Germans take the vitriol. As a group, they want to avoid future uses of ESM. Since all actual uses of EFSF/ESM to date have been at least partially a result of overly large banking sectors as a portion of GDP, the EU core want to see all the small banking havens within the EU have much smaller banking sectors. To do that, Cyprus was put up as an ‘example.’ EUR depositors now need to pick where they do their banking more carefully – banks in countries with excessively large banking sectors SHOULD be seen as riskier. The Troika INTENTIONALLY saved Cyprus as the last country to ‘solve.’ Since all the other, more important, EU countries has been ‘dealt’ with, depositors there are much less likely to be worried that they will share the same fate as the Cyprus depositors. This view holds that the broader financial fallout from Cyprus is tighter monetary conditions in the smaller EU countries with overly large banking sectors, as depositors leave in an ORDERLY fashion until the banking sectors shrink to size. Larger EU countries are likely to be largely exempted from this risk, as deposit flight has already occurred. In the meantime, the OMT / LTRO / ELA will provide sufficient cushion to ease the transition. This will ultimately result in a more stable EU-wide banking system in the long run.

The Fat Tail:

Note that in both of these scenarios, there is a real (and appropriate) concern of bank runs. Whether they materialize or not is yet to be seen, but many financial market participants have already acted, because the results could be catastrophic. Thus far, the situation has impacted asset prices, although CONDITIONS remain stable. As the chart below shows, in the past couple weeks, EU bank equity prices (white) and Financial CDS (orange) have already retraced much of their moves over the past few months. However, the 3m Euribor / OIS spread (yellow) hasn’t moved.

Over the next couple months, EU asset prices may well continue to deteriorate. But the key indicator of whether the crisis could spiral out of control is whether short term bank funding conditions worsen. A jump in the Euribor-OIS spread will likely be interpreted by market participants as indicative of a real bank run. Barring that, however, we may get a repeat of 2Q last year – when some soothing words from policy makers ultimately clamed market fears.

So – to summarize:

Current market concerns are clearly for a substantial worsening of EU liquidity conditions. These concerns are likely to persist in the near term. However, the larger picture may be more sanguine than feared. Watch EU funding conditions closely.

Notable:

  • EU Economic Confidence declined to 90 in March vs 90.5 exp and 91.1 prev
  • Canada Core CPI jumped to 1.4% YoY in Feb vs 1.0% exp and prev
  • Italian bond auctions were quite weak
  • The BOE said UK banks face a capital shortfall of 25bn sterling and that they need to raise capital to cover potential losses in stress test scenarios.
  • JPM: it is possible that the BoJ will announce just the outline of the additional easing on April 4th, leaving the details of the new scheme to the staff, especially if they do not get the agreement on the details of the consolidated facility of the APP and the Rinban. Should it happen, the detail of the scheme will be published on April 26th.
  • NY Fed: in both the pre-recession and recession periods, only 22 percent and 23 percent, respectively, of unemployed workers moved from routine to nonroutine jobs.

Upcoming Data:

  • Thu: Month End, German Retail Sales, Unemployment, EU Money Supply, Canada GDP, US Jobless Claims, Chicago PMI, USDA Ags Data
  • Fri: Good Friday, US Personal Spending, Core PCE, UMichigan Confidence
  • Mon: Europe Closed, South Korea HSBC Mfg PMI, China Mfg PMI, US Mfg PMI, RBA
  • Tue: EU PMI Mfg, UK PMI Mfg, Italy Unemployment, Australia Trade Balance, China Services PMI
  • Wed: US ISM Non-Mfg, Oil Inventories, Australia Retail Sales
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