Sucked into Europe's spatial disorientation

As the market's illogicality wreaks havoc with traditional modelling, 'good news is good and bad news is better', FX Concepts' John Taylor says. But with Europe's banks increasingly strained, Taylor warns we could be near a GFC-style cliff.

The intense strains afflicting the European banking sector were evident overnight, with Germany’s largest financial institution Deutsche Bank, reporting that net profit plunged by a third in the first quarter, as investors grew increasingly nervous about the region’s debt crisis.

At the same time, the European Central Bank has set up a working group to urgently examine how the eurozone’s bailout fund can lend directly to cash-strapped European banks.

According to a report in the German newspaper Sddeutsche Zeitung, the ECB’s move reflects growing concerns that Spanish banks are struggling to raise funds and are being forced to reduce lending to companies.

Spanish bond yields have risen sharply in recent weeks, reflecting growing fears that the Spanish government of Mariano Rajoy will fail in its attempt to push through tough austerity measures and may be forced to seek a bailout.

However, the ECB’s move is highly controversial as Germany, the Netherlands, Austria, and Finland are staunchly opposed to allowing the eurozone’s bailout fund to lend directly to banks.

In his latest note, John Taylor, chief investment officer of FX Concepts, the world’s largest currency hedge fund, argues that his firm is finding present market conditions extremely worrying for professional investors, because the "illogicality” of markets is wreaking havoc with its quantitative models.

"Nothing has ever looked like this before, and the comparisons are not even close. This is dangerous territory, a kind of spatial disorientation, not only for models but also for seasoned economic and monetary practitioners."

As a result, the fund has turned to history for guidance.

"There are many choices but the parallels are not strong enough to give us any comfort. Among them are the Great Depression, the early 1990s, the late 1970s, the late 1840s, and finally just before the end of the Ancien Rgime and just after the end of the US Revolutionary War."

The benefit of hindsight means that all of these tumultuous periods appear much easier to understand than the current situation, although for people at the time they would have been just as perplexing "remember it was Keynes who said that the markets can be illogical longer than you can remain solvent".

As a result, he concludes: "We are on our own, there is no history to help us. It is being invented as we go along and we have to figure this one out by ourselves.”

The biggest problem, he argues, is the crushing burden of over-indebtedness that is threatening the developed world. Major central banks – such as the US Federal Reserve, the ECB, the Bank of Japan and the Bank of England – clearly recognise this is the problem "because there can be no other reason for their extreme actions over the past year or two”.

As Taylor argues, "what the quantitative systems, the experts, and the authorities see is the growing crush of debt that has been slowly overwhelming the economic actors and threatening to destroy the way of life for those many hundreds of millions of people living in the ‘developed’ world."

"As the outright levels of debt have surpassed 300 and, often more than 400 per cent of the national GDPs, and contingent or future liabilities have grown to multiples of these levels, the situation has turned critical.”

As Taylor notes, the only painless way to escape this debt explosion is through a combination of real growth (which lessens the burden of old debt) and asset inflation – higher equity and housing prices (which makes it easier to liquidate assets to pay down debt).

"It is for this reason that the Fed, the ECB, the Bank of Japan, and the Bank of England, have brought interest rates down to zero (making the interest on the outstanding loans less onerous) and have pushed money into the banking system (making loans more plentiful and driving asset prices higher).

But Taylor notes that the US has made minimal progress towards reducing its debt-to-GDP ratio, while the rest of the world is going backwards.

As a result, "the authorities will not stop trying to keep asset prices up and to prevent defaults. If there is even a hint of an equity decline, a credit crisis, or major default, the central banks are quick to print more money or come up with a new scheme to hold things together. Every financial manager who is not catatonic knows this. As a result, good news is good, and bad news is even better."

This leaves investors in a quandary: "We all know that this low volatility market rally can’t go on, but we also know that the governments can’t let it end.”

How will this situation ultimately resolve itself? According to Taylor, "trying to do our job, we money managers struggle to figure out how this will end, looking for problems that might be so bad, that they are not good (i.e. the governments will be overwhelmed) because we would be crazy to allow our clients and our careers to be destroyed by another collapse similar to the one in 2008".

And Taylor warns this could come sooner rather than later. "Our models tell us that we could be near the edge of the cliff. With Francois Hollande about to win in France and the Greek election promising confusion, a sharp uncontrollable downmove, prompted by Spanish and Italian debt problems, is quite likely.”

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