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In Risky Times, It’s Crucial to Keep What You Have in Safe Places

By Hans Parisis
Tuesday, 12 Jun 2012 12:52 PM Current | Bio | Archive

After the U.S. markets closed Friday, S&P affirmed its “AA-plus” rating for the United States, citing strengths that include “its resilient economy, its monetary credibility, and the dollar's status as the world’s key reserve currency.”

However, S&P kept the outlook negative and warned it could downgrade the United States by 2014 if political and fiscal risks continued to build.

Investors should remember that at the end of 2012 and the beginning of 2013, many major fiscal events are set to occur at once. These fiscal events include the expiration of the 2001 tax cuts under President Bush, the winding down of certain jobs provisions, the activation of the $1.2 trillion across-the-board “sequester,” an immediate and steep reduction in Medicare physician payments, the end of current Alternative Minimum Tax (AMT) patches, and the need to once again raise the country’s debt ceiling.

Indeed, at the end of 2012, the U.S. faces what Federal Reserve Chairman Ben Bernanke calls a “fiscal cliff.”

Taken together, these policies would reduce 10-year deficits by over $6.8 trillion relative to realistic current policy projections, enough to put the debt on a sharp downward path but in an extremely disruptive manner.

If policymakers were to walk away from this potentially action-forcing moment to help them put U.S. debt on a sustainable path, it could lead to a loss of confidence in their ability to govern that could set off a dangerous chain reaction in markets. Earlier this year, other rating agencies like Moody’s already have also indicated that such action could result in downgrades of U.S. debt.

San Francisco Fed President John Williams, a voter on the Fed’s policy-setting panel that meets June 19-20, said that “while the global financial system is stronger that it was three years ago, it remains vulnerable and in the worst case, the European crisis could undermine the financial improvements" in North America and Asia.

"The European sovereign debt crisis threatens banks in that continent, and, by extension, elsewhere," he said. "The European situation is one that we're monitoring very closely, and it does give one pause about what it means for the U.S. economy and the global economy.”

No doubt, the most significant threat to the U.S. economic outlook comes, for now at least, from the deterioration in global financial conditions.

Financial conditions in the U.S. have tightened since the Greek election on May 6, and, if the situation in Europe deteriorates further, the U.S. is likely to experience a much more substantial tightening of financial conditions.

For Europe, I can’t see any light at the end of the eurozone “fracturing” tunnel and I expect financial conditions in Europe to deteriorate significantly in coming weeks, particularly following Greek elections on next Sunday, June 17.

By the way, after Switzerland said last month it was considering introducing capital controls if the euro fell apart, investors should take notice that European finance officials have told Reuters: “Limiting the size of withdrawals from ATM or “cash machines” as they call them in the U.K., imposing border checks that should imply the possibility of suspending the Schengen agreement, which allows today visa-free travel among 26 countries, including most of the European Union, as well as introducing eurozone capital controls as a worst-case scenario should Athens decide to leave the euro” have been discussed.

That said, if the strains on European financial institutions should become acute, the Federal Reserve would likely act swiftly to provide liquidity to foreign central banks and possibly U.S. financial institutions in order to minimize systemic risks to the U.S. financial system.

As we have experienced on Monday, developments in Europe will continue to weigh on U.S. financial markets even if U.S. financial institutions aren't threatened. Given the relatively modest momentum in the U.S. economy that was confirmed by the just released OECD composite leading indicators (CLIs) continuing to signal improvements in economic activity in the U.S. and Japan, notwithstanding the deceleration in these countries’ CLIs over the last four months provides “tentative” signs that growth may moderate in the near term.

In this context, I wouldn’t be surprised to see the Federal Reserve implementing additional monetary easing at some time in the near future in order to offset a further tightening of U.S. financial conditions in case that should occur.

But investors should take note that “we’re not there yet!” And after assessing recent comments from Federal Reserve officials as well as the increased downside risks to the economic outlook, I still don’t expect a change in U.S. monetary policy at next week’s Federal Open Market Committee (FOMC) meeting. I expect the FOMC in a wait and see mode, but ready to act.

Coming back for a moment to what’s “going on” and what’s “not going” in the eurozone, we saw the benchmark Italian 10-year yield only 8 basis points (bp) below where the equivalent Spanish paper stood “last Thursday.” Italy’s yield on its 10-year sovereign debt was once again challenging the recent highs just above 6 percent.

If you ask me, and even if the Italian yield move wasn't quite as aggressive as the move in Spanish yield, to me it clearly suggests that the spotlight is now also slowly beginning to turn onto Italy. Just think for a moment and because there is now about 100 billion euros ($125 billion) of additional support for Spain, although we’ll have to wait at least until June 21 to know what amount will be considered, all this means there should be “theoretically” less available to support Italy in case a so-called rescue should ever be needed. Food for thought for every long-term investor, isn’t it?

Over the weekend, the Eurogroup has finally agreed to provide up to 100 billion euros ($125 billion) financial assistance through the EFSF/ESM (European Financial Stabilization Mechanism/European Stability Mechanism) for recapitalization of the Spanish financial institutions.

As usual, one of the key questions: “Who will bear the losses accumulated in the Spanish banking system?” remains unanswered. Investors should keep in mind the amount of 100 billion euros ($125 billion), or more, will depend on an independent assessment of the needs of the Spanish banks and may not be enough.

On the surface, the amount the Eurogroup puts forward appears around three times the 37 billion euros ($46 billion) the International Monetary Fund (“IMF”) says is needed. Investors should keep in mind the capital requirements of Spanish banks may turn out to be much higher and as much as 200-300 billion euros or 250-375 billion dollars.

“Risk-off” and keeping “what you have” in “safe places” that have proven in the past you can really trust them, remain on top of my preference list.

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