No, Prime Minister, Spain Is Not Uganda

“Aguanta, somos la cuarta potencia de Europa. España no es Uganda.”
---Text message from Spanish prime minister Mariano Rajoy to his finance minister earlier this year.

I’ve been in the credit analysis business since 1978 and I have seen more than my share of “good” credits turn bad. Among them: Continental Illinois, E.F. Hutton, Drexel Burnham, Latin America, Security Pacific, BofA (the first time), the New York money center banks, the Texas and New England banks, the entire S&L industry, Mutual Benefit Life, BCCI, Mexico (again), Credit Lyonnaise, WestLB, Thailand, Korea, Russia, Lehman Bros. (the first time), Argentina (again), Enron, Arthur Anderson, the entire merchant energy industry, the California utilities, WorldCom, Global Crossing, Bear Stearns, Northern Rock, IKB, Allied Irish, HBOS, Lehman Bros. (the second and final time), Merrill Lynch, BofA (again), Citigroup, Greece, Ireland, Portugal, and now.....Spain.

When credit is all you do, your gut sense should become as educated as your intellect. Good credit people should be able to smell bad credits. When Enron began to unravel in the fall of 2001, I read their 2000 Annual Report. As I read, I got a pit in my stomach, almost a panic reaction. Enron’s glossy and entirely invented report was a blinding array of flashing red lights and warning klaxons. I felt in my stomach the utter bottomlessness of their financial situation. Similarly with Thailand and Korea. 

What each of these credits (and many of the other catastrophes listed above) had in common was this: a credit whose trajectory was upward. Bad credits (like Uganda) don’t have credit crises, because they don’t depend on market confidence. It is only the “stars” and the “tigers” and the “most admired” companies and countries like Spain that suffer crises because their psychology and their finances were geared for growth, not for reversal. Bad credits are generally ponzi schemes in the sense that they must continuously borrow more to stay afloat.

Recently I have began I to feel that same fear with respect to Spain, the fear that, like Enron, it is beyond rescue. Like Enron, Spain’s finances are not structured for a credit crisis, only for ponzi-like growth. A cut-off of credit is fatal. I am worried that rescuing Spain is beyond the capability of the mechanisms established to do so. A rough estimate of the price tag for Spain is EUR one trillion, although it could be higher. That is an astronomical sum.

We are not talking about a $30 billion Enron, or a $100 billion Mexico or a $35 billion Greece. Spain is the largest sovereign credit problem since Germany in 1931 . Spain owes the world about a trillion euro in a currency that she doesn’t print.

Unlike the LDCs, she can’t simply impose a payments moratorium and reschedule her bank loans, because her debts are in bonds and deposits, not loans. It is true that many of her official creditors can roll her debt if they choose, and they will have to. But the bulk of her debt remains in unofficial hands, which will not voluntarily roll it as it matures. Spain needs to borrow money from somebody to repay her debt maturities as they come due. That’s hundreds of billions between now and the end of next year. I also don’t know if the ECB will be able to replace all of her banks’ market liabilities with its various loan programs, no matter how low its collateral standards. That’s another huge challenge.

Draghi recently gave a speech in Berlin in which he tried to put a brave face on the situation. Here is the nugget of his remarks:

“My central message to you today is that, provided that all policy-makers persevere with the necessary reforms, we have a number of reasons to be positive about where the euro area is heading. We are seeing signs of improved sentiment in financial markets and we expect the economy to return to growth next year. At the same time, considerable progress is being made on all fronts to strengthen the foundations of the euro area.”

Does that make you feel even slightly better about Spain? When I read this I got that bad credit feeling again. I got the feeling that the captain of the ship wants us to believe that morale-strengthening exercises will restore market confidence, and the ship will sail on.

I have given up on deciding whether Draghi is smarter than all of us, or is himself delusional. In the end it doesn’t matter. Like King Canute, he cannot stop the tide from rising. There is no relationship between what Draghi is saying and what he would ultimately have to do to rescue Spain. So what if he knows the truth? What difference does that make? How is he going to come up with the money he needs as long as the eurozone's price-stability suicide pact remains in place? He has no path to victory, only more of the same disastrous policies with minor tweaks here and there. He says that the OMT is unlimited, which means in practice one trillion euros: can he do that with his current governing council?

This is where my head is at on Spain, that it is a “caso perdido”. Short-term, it can get rescued and the OMT can help. But the restoration of market confidence and market access seems like a chimera. Spain can’t throw her engines into reverse because there is no such lever on her control panel. She needs a new central bank, quickly.

Spain On The Brink Of A Downgrade To Junk

The Baa3 long term debt rating of the Spanish government remains on review for possible downgrade. The review commenced on 13 June 2012 and will likely continue through the end of September because of pending information on:
(1) the scope of the bank recapitalisation needs;
(2) the nature and size of support mechanisms available under the European Stability Mechanism (ESM) in light the upcoming German Constitutional court ruling; and
(3) potential changes and additions to the existing crisis-management framework as policymakers reconvene in the next few weeks to discuss policy options in a number of areas, including the further advancement of a banking union.
--Moody’s, Aug. 30th, 2012

Moody’s said in August that it would conclude its review of Spain’s near-junk rating by the end of September, which I guess means the end of this week. They now have answers to all three open questions listed above, so they need to decide.

Moody’s must decide whether (in its opinion) Spanish government bonds are suitable as an investment for fiduciaries, or should instead be viewed as a speculative investment unsuitable for widows and orphans. An end of the review with a confirmation at Baa3 would seem to be out of the question. Either they will extend yet further the review (punt), or take the rating to Ba1 or Ba2.

While an opinion about the future can await additional information, it is at risk of becoming journalism rather than opinion. Moody’s could wait forever to decide the review but that wouldn't be very helpful to investors.

My guess is that the rating will go to Ba2 with a negative outlook. In my opinion, while Spain will be helped in the short-term by the eurozone’s “crisis-management framework”, it is doomed in the end to default and redenomination, as long as the ECB sticks to its price-stability suicide pact. Moody’s view appears to be bit more nuanced in favor of the possible success of the muddle-through scenario, but investment grade seems inappropriate for a country with spiralling debt, an intractable fiscal deficit, and 6% bond yields. It just smells speculative.

Assuming Spain’s bond rating goes to junk, yields should rise slightly, although most investment grade portfolios dumped Spanish risk long ago. But there will be a few stragglers forced to sell by the downgrade. Of course, the downgrade to junk and the falling price of Spanish bonds will have no impact on the ECB’s collateral standards or on European bank accounting. Spain remains risk-free in the Alice-in-Wonderland that is Europe. “We don’t need anglosaxon ratings on European bonds.”

Presumably, the downgrade will hasten Rajoy’s non-application application to Europe for help, although it really isn’t up to him. It’s up to Draghi, and how long he can wait for the Spanish banks to be recapitalized to his satisfaction. He can put his foot on the oxygen hose whenever he chooses. But even Sr. Draghi must view Spanish government bonds at 100 cents on the euro, because he too lives in Wonderland.

Cyprus Tells Troika To Take A Walk

Ruling party in Cyprus rejects troika's bailout demands
Cyprus’s ruling communist party, AKEL, rejected key demands in a proposal from international lenders, while pushing for steps that foster growth and for bailout talks to proceed, party chief Andros Kyprianou said on Monday.
AKEL, the party of Cypriot President Dimitris Christofias, cannot accept a proposal by the so-called troika that oversees euro-area bailouts to end the indexation of public sector wages and suspend the practice in the private sector for the duration of the rescue program, Kyprianou said in an interview in the capital Nicosia.
The party also dismissed the troika’s call for a privatization timetable.
“The package, the building blocks submitted by the troika lack proposals aimed at boosting growth,” Kyprianou said. “In all the other countries where the troika’s proposals were implemented, not only have their economies failed to recover, but their recessions have been deepened.”
Officials of the troika, drawn from the European Commission, the European Central Bank and the International Monetary Fund, are unlikely to return to Cyprus to restart bailout talks until at least mid-October, a Cypriot official said last month.
Kyprianou said talks with the troika must begin “without delay” and proceed “as quickly as possible so that we can conclude before Cyprus needs additional funds.”
---Kathmerini (Athens), 02 Oct. 2012

Why, you might ask, is tiny bankrupt Cyprus quibbling over the terms of the bailout that it needs to avoid complete economic and financial collapse? The answer is: because they know what Greece and Spain know, which is that Europe will pay any price to prevent exit by any eurozone government, no matter how negligible.

Cyprus can play “chicken” with the Troika just as well as Spain. And because the bill is only around EUR 10 billion, they can be pretty confident that Europe will pay it before Cyprus runs out of money. The Cypriots are famously shrewd, and they won’t be rolled. Just ask Turkey.

Central Banks Are Too Busy To Buy Bonds

September must be Diversity Training Month at the world’s central banks because they seem to have taken the month off.

This month the ECB, the BoJ and the Fed all announced big splashy bond-buying programs.. The ECB announced “unlimited” Outright Monetary Transactions to buy the bonds of compliant governments. The BoJ announced a Y10 trillion increase in its JGB Asset Purchase Program. The Fed announced its open-ended QE3+, wherein it would buy mortgage and agency bonds until its full employment mandate was fulfilled.

These announcements, coming at the same time, pushed equity markets up around the world. Now the markets are falling back, and some pundits are already calling the exercises a failure. Let's look at the facts..

We start with the inscrutable Japanese. On the 19th the BoJ announced that it would add another Y10 trillion ($100B) to its existing Y70 ($700B) trillion APP. Two observations: (1) twenty years of BoJ failure have shown that incremental purchases accomplish nothing; and (2) the BoJ’s recent announcement is meaningless. It merely continues the bank’s existing QE program, which is tiny compared to other countries and which has--surprise!--not worked.

The BoJ currently shares the title for World’s Worst Central Bank with the Reserve Bank of Zimbabwe. Under the BoJ’s care, Japan has experienced over twenty years of negative nominal growth and an increase in government debt from 70% of GDP in 1992 to 220% today. What should have been paid for in rising nominal tax revenue over those years was instead purchased with IOUs. Frankly, it is now too late for Japan: the inflation that it will take to dissolve the debt mountain will bankrupt the banks many times over. The endgame will be either default or high inflation. Bottom line: No good news.

Next, let’s look at the hapless Europeans. Draghi made his big announcement on the 6th. Activity to date: nothing. Even though both Ireland and Portugal are fully qualified for the ECB’s bond buying program, they have yet to receive the slightest benefit. Perhaps OMT wasn’t meant for puny countries but rather as a firewall around Spain. At some point in the future, Spain may see fit to beg for help and become a beneficiary. But so far, the ECB hasn’t bought a single bond under OMT. And, although OMT is not a QE program (unfortunately), it is noteworthy that the ECB’s balance sheet is contracting. That makes sense, since higher unemployment will help to underpin price stability.

Now for the Americans: more nothing. Instead of expanding its balance sheet as promised, the Fed’s balance sheet has actually shrunk since the big announcement. In its statement, the FOMC said that “The purchases of additional agency MBS will begin tomorrow (9/14), and are expected to total approximately $23 billion over the remainder of September.” Well, as of yesterday the Fed’s MBS is down by $9 billion, and September is now over. I don’t mean to be churlish, but is it really that difficult to print money and buy bonds?

So I have two points to make: (1) these banks should start putting their money where their mouth is and get on with it; and (2) in the case of QE3, don’t say that it isn’t working, because it hasn’t started yet. If Bernanke actually does what he said he’ll do, the stock market will take notice.

Europe Is Holding A Bake Sale For Greece

A month ago I posed the question “Will Greece blow up before election day?”, and answered no. I said no because the consequences of Grexit are unknown, and the cost of endless bailouts is cheaper than default, repudiation and general chaos. No one wants Greece to blow up, not now.

I said that the facts would be fudged and the bailout would be provided on the basis of meaningless Greek promises (redundancy). I also said that the IMF will be harder to “fix” than the ECB or the EU, since the IMF is not controlled by the EU, notwithstanding the woman who heads it.

That remains my prediction. However, pulling off this trick won’t be easy. Everyone agrees that Greece must be bailed out, but that is where the agreement ends. It appears that there are at least three flies in the ointment: the IMF team, which has not been co-opted by Lagarde;  the Bundestag, that won’t give Greece any more money; and the Greek people, who are going on strike tomorrow to demand free money from the sky.

A Grexit can only be prevented by forgiving Greece its sins, “extending” all of its deadlines, and throwing in another EUR 20 billion to keep it afloat until the next bailout. It is easy to forgive sins and extend deadlines; it is not so easy to come up with another twenty billion in bailout money. The IMF has said no to any more money. The EFSF/ESM can’t provide it unless the IMF is on board (so they say), and unless the Bundestag authorizes it. The ECB can’t provide it, because Greece is noncompliant with the Troika. And the Greek government will not agree to the latest austerity plan unless they are paid twenty billion to do so.

What’s a mother to do? Merkel will have to figure out a way to get her coalition to approve the new money, which it is loathe to do. We are witnessing the consequences of the constitutional court’s decision to give a veto to the Bundestag. All additional EU bailouts must be approved by the Bundestag, which is not made up of Brussels bureaucrats or French socialists. The elected German politicians must either approve all future bailouts, or must be responsible for the “End of Europe”.

This would all be easier to handle if Greece were located on the southern border of the US, because then it would have full American support, as Mexico did in 1994. Without American leadership and support, the financial geniuses on the Continent must solve this crisis on their own. They will solve it, but they haven’t yet figured out how.

In any case, Europe is doing its small part to re-elect the president by ensuring that this crisis will drag on past the November election. The Dow must not be allowed to crash for the next six weeks!

Spain Remains A Basket Case

Aside from the Greek circus, Spain is now the cockpit of the eurozone government debt crisis. How does Spain look as she confronts the need for a big bailout?

For the sake of this discussion, let’s agree that the ratio of government debt to GDP is a good measure of sovereign risk. Both government debt and GDP are nominal figures; no complicated constant dollar calculations are required. Government debt grows at the rate of beginning period debt plus the current year’s fiscal deficit in current dollars. For the D/GDP ratio to stabilize, nominal GDP must grow at the same rate as the deficit as a percent of GDP. Not rocket science.

Let’s take a look at Spain’s numbers.

Spain’s nominal GDP (EUR B), as calculated by the OECD, has been pretty flat:
2006: 986
2007: 1,053  (+7%)
2008: 1,088  (+3%)
2009: 1,048  (-4%)
2010: 1,048  (+0%)
2011: 1,063   (+1%)

Spain’s general government fiscal deficit as a % of GDP as calculated by Moody’s has been high:
2007 (+1.9%)
2008 (-4.5%)
2009 (-11.2%)
2010 (-9.3%)
2011 (-8.9%)
2012 (-6.6%) est.

Spain’s central government debt (EUR B), as reported by the Tesoro Publico, has grown rapidly:
2007 307B
2008 358 (+17%)
2009 475 (+33%)
2010 540 (+14%)
2011 592 (+10%)
2012 605 (July) (+2%)

Spain’s general government debt to GDP ratio (%) as calculated by the Fed has risen by 250%:
2007 36%
2008 40% (+4%)
2009 54% (+14%)
2010 61%  (+7%)
2011 69%  (+8%)
2012 91% (proj.) (+22%)

That is what the ECB is facing, as it seeks to facilitate Spain’s effort to become a creditworthy sovereign issuer. Spain’s numbers are all going in the wrong direction. The ECB can help to refinance Spain’s maturing debt at affordable rates (if it tries hard enough). But it can do nothing about Spain’s large fiscal deficit, which only the government (with the Troika’s help) can fix. And the ECB has announced no plans to raise the eurozone’s rate of inflation or the rate of nominal GDP growth. The outlook is grim.

Looking forward, Spain’s nominal GDP growth outlook is at best modest (zero?), while its fiscal deficit is unlikely to get much below 5-6% of GDP, despite whatever cuts Spain eventually agrees to. Thus, the medium-term outlook for Spain’s debt ratio is a steady annual increase, in the direction of higher credit risk, lower credit ratings, and higher bond spreads. Spain will remain a deteriorating credit until its budget comes into a sustainable balance and its GDP starts to grow in a sustainable way. Neither are likely without much higher inflation in the eurozone (which had been experiencing deflation until recently).

Moody’s currently rates Spain at the bottom of investment grade (Baa3), with the rating under review for possible further downgrade (to junk). In a recent comment on the continuing review for downgrade (expected to end soon), Moody’s sounded pessimistic in observing that:
“official support beyond banking recapitalisation but short of a full package may also pressure the rating below investment-grade if (1) the combined measures were unlikely to succeed in maintaining ample market access; or (2) if these measures were effectively providing the bulk of the Spanish government's funding needs through crisis-management tools such as the European Financial Stability Facility and ESM, and European Central Bank actions that provide liquidity to government debt markets. Short of the accompanying fiscal and structural reforms being successful, full return to market access at the end of these initiatives may prove very difficult, raising the risk of private sector participation in a debt relief effort before more official support is provided.”

That sounds to me that Moody’s will either downgrade Spain or extend further its review (begun three months ago). Most likely they will take the rating to Ba2/negative outlook (which won't lower bond yields).

My overall conclusion is that while the OMT can help to overcome the market’s reluctance to buy Spanish debt, it can’t fix Spain debt trajectory. That can only be done by politically unpalatable austerity combined with massive unsterilized QE by the ECB. By sterilizing the OMT program, the ECB has condemned Spain to a future of zero growth, weak government revenue, and rising debt ratios. Let us hope that Bernanke’s QE3+ will succeed, and provide a model for the ECB before it is too late.

There Is No Such Thing As Conservative Monetary Policy

“Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”
--J.M. Keynes, General Theory

"Gold was an objective value, an equivalent of wealth produced. Paper is a mortgage on wealth that does not exist, backed by a gun aimed at those who are expected to produce it.”
--Ayn Rand, Atlas Shrugged

I am a proud member of the party of free enterprise, individual liberty, and sound economic policy. The GOP stands against all of the little tendrils of neomarxism that have found their way into the Party of the People. We stand for a balanced budget, limited government, and thrift. We want America to prosper, and for a prosperity shared by all, as opposed to the growth-destroying redistributionism of the Left. We have smart economists who can patiently explain what is necessary create the conditions for growth. We believe that we are the party of growth.

However, my party also has a dark side (yes, imperialism, but in addition to that): a sound dollar. Who could be opposed to that? We don’t want the US to become Argentina or Zimbabwe do we? We don’t want to live in a country which periodically slices the zeros off of its currency, and where you to carry a calculator to figure out what things cost in “real money”, do we? No, we don’t. We want a “sound currency”.

And so, the House GOP deputy whip, Kevin Brady, has introduced the “Sound Dollar Act of 2012”. Boy, who could be against that besides Barney Frank?

The bill begins with the “finding” that:
“Monetary policy can only affect the level of employment in the short term because nonmonetary factors determine the level of employment in the long term...Therefore, to maximize long-term economic growth and achieve the highest sustainable level of real output and employment, price stability should be the objective of monetary policy.”

The bill then proceeds to eliminate full employment from the Fed’s mandate: “Section 2A of the Federal Reserve Act is amended(1) by striking ‘‘goals of maximum employment, stable prices, and moderate long-term interest rates’ and inserting ‘‘goal of long-term price stability’’.”

To be honest, as a conservative/libertarian, I don’t fully understand why the right of my party is opposed to the full employment mandate. Those of us in the “market monetarist” camp tend to be pretty conservative. We believe that prosperity leads to sound policy, while depression leads to leftist nostrums like  green jobs and ObamaCare. But the “hard money” guys somehow see the Fed as an ally of the Left. Romney and Ryan are criticizing QE3 as “another bailout” and a short-term “sugar rush” to re-elect Obama.

Another Republican statement (Rep. Raul Labrador) on this subject: “It is going to sow some growth in the economy, and the Obama administration is going to claim credit.” Labrador is objecting to QE3 because it might help the economy.

Right now, the small but influential “market monetarist” community is happily celebrating last week’s victory, when Bernanke finally agreed to acknowledge the Fed's full employment mandate and--hold your hat--to target employment as an explicit objective of Fed policy. The market monetarist community feels that there has been a major intellectual breakthrough in D.C., and they (see: Wolfgang Munchau at the FT) are seeking to export this breakthrough to the eurozone, where it is so desperately needed.

These celebrations may prove premature. I recently received an email from the Romney-Ryan team, which said:
“This past week, the Federal Reserve announced it would print $40 billion every month to prop up this administration's jobless recovery -- that's money we can't afford for jobs we will never see.”
Those words are not music to the ears of market monetarists. The GOP seems to be doubling down on sound money.

The market monetarist school may have a short life in power if it is unable to convince the Congress and the next president that full employment is not a left/right issue, and that good growth policies have no ideology. Appropriate monetary policies are not only a moral imperative (if one sees unemployment as a bad thing), but also a fiscal imperative if we are ever to stabilize our debt-to-GDP ratio. It is the only way that we can have GDP outrun our debt mountain.

The House GOP are currently slaves not to a defunct economist, but to a defunct philosopher and novelist, Ms. Alisa Rosenbaum (Ayn Rand). It is unfortunate that Ms. Rand harbored opinions concerning monetary policy. I am sure that Ms. Rand’s experiences in the early days of the Soviet Union were enlightening, but they gave her the wrong idea about inflation.

A Brief Introduction To German Constitutional Law

Excerpts from the Sept. 12th decision of the Federal Constitutional Court:
“The ESM Treaty may only be ratified if, at the same time, it is ensured under international law that the limitation of liability limits the amount of all payment obligations arising to the Federal Republic of Germany from this Treaty to its share [EUR 190 billion] in the authorised capital stock of the ESM and that no provision of this Treaty may be interpreted in a way that establishes higher payment obligations for the Federal Republic of Germany without the agreement of the German representative.
“The German Bundestag is prohibited from establishing mechanisms of considerable financial importance which may result in incalculable burdens with budget significance being incurred without the mandatory approval of the Bundestag.
“To what extent the decision taken by the Governing Council of the European Central Bank on 6 September 2012 on a programme concerning the purchase of government bonds of financially weak Member States whose currency is the euro complies with these legal requirements was not a matter for decision in the present proceedings.”

For my sins, I actually read the Constitutional Court’s entire decision (in translation). I have excerpted what I think are the crucial parts. The court permitted the government  to sign the ESM treaty on the proviso that it does not bind Germany to future expenditures beyond its initial capital contribution of  EUR 190 billion. The Court did not express an opinion concerning Draghi’s OMT, although plaintiffs had asked it to do so.

The court’s decision has been widely interpreted as a green light for greater fiscal integration. Indeed, Jose Manuel Barroso, the president of the European commission, called for a federal European state in his annual “state of the union” address: "I call for a democratic federation of nation states that can tackle our common problems, through the sharing of sovereignty." Barroso said that a federation of Europe is "unavoidable" if Europe's embattled common currency is to survive the financial crisis. His aides said that he plans to recommend a plan for common eurozone bonds.

Somehow I fear that the president of the European Commission may not yet have read the Constitutional Court’s decision. It is as if the Court said the opposite of what it said, or that what it said doesn’t matter. The Court specifically prohibited the ratification of any treaty that bound Germany to pay or owe any more money than EUR 190 billion, which absolutely excludes the possibility of a eurobonds or a fiscal union. As best as I can tell, it also ruled out the idea of the ESM’s leveraging itself by borrowing from the ECB or the capital market.

In my view, this means that the ESM will be quite limited in scale, and will not be big enough to be helpful to either Spain or Italy. It will merely serve as the gateway to the ECB’s bond buying program--which will be challenged before this court.

If Barroso is correct that only a federation can save the eurozone, Germany’s constitution will need to start “evolving” very quickly.

Bernanke Hits It Out Of The Park

FOMC Statement, Sept. 13th, 2012:
“If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”


It may be safe to fight the Fed when it is floundering around ignoring its employment mandate. It isn't safe to fight the Fed when it decides to achieve its mandate.


I had predicted that the FOMC would announce another round of QE, in the amount of $500B. I criticized the decision in advance by saying that the Fed should target outcomes rather than endless incremental inputs.

I was wrong; I underestimated Bernanke’s powers of persuasion with the hawks.
It looks like he has finally used his considerable authority to begin to practice what he used to preach as a professor.

He has announced that the Fed will continue to buy securities (QE3+) until the outlook for the labor market improves substantially. While it is true that he will do this in increments of $85 billion per month, he made an open-ended promise to keep buying bonds until his target is achieved. This is a major intellectual breakthough for the Fed.

The Fed has begun to do what the ultra-doves (the “market monetarists”) have been begging for since 2007: use its unlimited resources to fulfill its full employment mandate.

I wonder if the hawks fully understand what they have just signed up for or, if they do understand it, whether they really mean it. That is because, I think it will cost at least another one trillion for the Fed to achieve its new target, and maybe two trillion. 

That means that the Fed will have to buy bonds at $85 billion per month for one to two years. That is probably beyond Bernanke’s tenure in the job. Who knows what the next chairman will think of this policy? And if ever inflation dares to rise one iota over 2%, the Fed will have an excuse to stop the whole exercise.

Unlike the Supreme Court, the Fed is not bound by its own precedents, and can change its mind at any time (as it just did). Nonetheless, this is the first time in history that the Fed has targeted employment growth by any means necessary.

In the past, the Fed's weapons were conventional (interest rates) and unconventional (incremental QE), but never open-ended QE. The last time something like this happened was when FDR horrified economists by raising the price of gold until commodity prices recovered (which was 100% successful).
In my view, it is no longer safe to fight the Fed. The Fed has gone nuclear, and it can't lose at least as long as Bernanke is chairman. The era of weak recovery and high unemployment is over, if Ben follows through. The risk of an inflationary shock is low. Therefore, the Equity Risk Premium is high at the same time that the earnings outlook is good. Also, no matter what happens in Europe, the Fed can overcome it as long as it pursues its new policy. I find it hard not to be bullish. I am buying SPY.

Looking For Black Swans In The Eurozone's Infirmary

I thought that this might be a good time to take a quick look into the eurozone’s ICU to see how the PIIGS are doing. My particular interest is in identifying any countries that look likely to blow up this fall. I will review the PIIGS in the order of their current Moody’s bond rating, from highest to lowest.

Italy
(Baa2/Negative Outlook. Barely eligible for investment grade portfolios. Bonds at 5.1% trade as a Baa3.)

Italy is the Big Enchilada of the PIIGS.  As a major economy with EUR 2 trillion of debt, it is way too big to be allowed to default. However, refinancing a debt burden on that scale cannot be handled by the EFSF/ESM. It would require the full resources of the ECB, and then some.

Italy’s bond yield has been quite volatile. It was as high as 7.2% last fall. Since the OMT was announced, it has fallen to 5.1%, which is still too high.

Moody’s downgraded Italy from A3 to Baa2 in July, providing the following rationale:
“A key factor underlying Moody's two-notch downgrade was the assessment that the risk of a further sharp increase in Italy's funding costs or the loss of market access has increased due to fragile market confidence, contagion risk emanating from Greece and Spain and signs of an eroding non-domestic investor base. The risk of a Greek exit from the euro has risen, the Spanish banking system will experience greater credit losses than anticipated, and Spain's own funding challenges are greater than previously recognized. In this environment, Italy's high debt levels and significant annual funding needs of EUR 415 billion (25% of GDP) in 2012-13, as well as its diminished overseas investor base, generate an increasing liquidity risk. The second driver of the rating action was the deterioration of Italy's near-term economic outlook, as manifest in both weaker growth and higher unemployment, which creates risk of failure to meet fiscal consolidation targets. Failure to meet fiscal targets in turn could weaken market confidence further, raising the risk of a sudden stop in market funding”.

So far, Monti seems to be hoping that the ECB’s OMT announcement plus further reform  at home will bring Italy’s bond yields down further, which I doubt. His fiscal situation will worsen, and his government’s domestic power position will continue to decline. In the end, Monti will have to apply to the troika for assistance, and the ECB will have to move heaven and earth to establish an informal yield ceiling.

Spain
(Rated Baa3, on review for downgrade. Moody’s says that its review will continue through the end of September. Spain is already ineligible for most investment grade portfolios. Trading as a Ba1 at a yield of 5.6%.)

Spain, with EUR 750 billion of debt, is Europe's other big problem. Although Spain’s bond yield has come down since the OMT announcement, it is still high at 5.6%. The Spanish banking system has been steadily losing deposits due to convertibility risk (which is, of course, “unthinkable”).  Spain requires help from Europe to pay its maturing debt, recapitalize its banks, and bail out its regions. Rajoy has been slowly going through the stages of grief and is currently moving from denial to bargaining.

Because Spain is too big for the EFSF/ESM to rescue, it ultimately will be up to the ECB to bring Spain’s yields down to a financeable level. The immediate question is the size of the capital hole in the banking system. The longer that Rajoy waits to apply to the Troika for assistance, the more likely Moody’s is to downgrade Spain to below investment grade, which will add to the pressure.

Ireland
(Rated Ba1/Negative Outlook. Ineligible for investment grade portfolios. Bonds at 8.2% yield trade at their rating level.)

Ireland is the Troika’s poster boy for compliance and success. Ireland has executed its austerity program and is on track for continued fiscal consolidation.

Moody’s says that it  “sees a possibility that the end of the current support programme at year-end 2013 will not only prompt a need for further rounds of official financing, but that private sector creditor participation is also to be required as a precondition for such additional official support.”

One can only hope that Moody’s is mistaken in suggesting that the Troika will require a bond default as a precondition for additional assistance, since this would make Ireland a credit like Greece. Europe can’t be that stupid.

As a fully-compliant government, Ireland should be the first in line for bond purchases under the OMT. They don’t even have to apply. It will be interesting to see if the ECB steps up. I can see no reason why they shouldn’t, if they want the program to have any credibility. Let’s see how fast Draghi can bring down Ireland’s yields. What is he waiting for?

Portugal
(Rated Ba3/Negative Outlook. Ineligible for investment grade portfolios. Bonds yielding 8.1% trade at their rating level.)

Portugal remains in austerity hell. It has no market access, is in permanent depression, and still faces major additional cuts. It is on track but has a long way to go, with no light at the end of the tunnel.

Moody’s assessment is quite pessimistic: “considerable uncertainty over the prospects for institutional reform in the euro area and the increasingly poor macroeconomic outlook across the region will continue to weigh on already fragile market confidence and make it difficult to reverse Portugal's adverse government debt trajectory”. Moody’s adds that a Greek exit would not be helpful for Portugal.

Greece
(Rated C, in default; remaining bonds yield 22% in anticipation of a second default.)

Greece, on permanent life support from Europe, is way off track in the implementation of its Troika-designed program. It has done almost nothing to comply, and prefers rioting to reform. Greece is the proof that there is almost nothing that a eurozone government can do to get kicked out of the eurozone. Europe knows that a Greek exit would be another Lehman event and would put intolerable pressures on the other PIIGS. The Greek negotiators know that. I expect that Greece will get its money by once again agreeing to a plan it has no intention of implementing. Greece is impossible to reform and too big to fail.

Conclusion
If you want to gauge these five credits as potential black swans, you’d have to start with Greece, although I am confident that Greece will get bailed out no matter what. Next would be Spain which is playing chicken with Europe on the terms of its bailout, but this is political theater. Spain will have to apply, so the risk of an unanticipated explosion is low. Italy may be the sleeper of the bunch, because most of her plausible scenarios are on the downside, as Moody’s stated. Time is not on Monti’s side, and his credit is likely to worsen.

Because neither Italy nor Spain can be rescued by the ESM, they will ultimately have to be rescued by a display of shock-and-awe by the ECB. By shock-and-awe, I mean massive unsterilized bond buying. That can only occur when Draghi has enough votes. Let’s hope that, when one of these behemoths starts to keel over, Draghi will have the votes to do something.