MacroScope

An eerie euro zone calm

By Mike Peacock
March 16, 2012

I don’t want to be the idiot who asked “is it all over?” … but is it all over?

Almost certainly not, is the answer. Greece is shored up for now but Portugal will probably need to follow it in seeking a second bailout and Spain, heading back into recession, will have to make deep, deep cuts over the next two years to meet EU deficit targets. Greek and French elections could easily upset the apple cart, the former producing a fractured government with less will to tread the austerity path, the latter a new president who wants to renegotiate the bloc’s new fiscal rules (though neither are guaranteed).

In Italy, a lot of faith continues to be placed in Monti but the proof of his ability to deliver the structural reforms needed to regalvanise the economy has yet to be seen. On that front, the Italian government is talking with trade unions during the week on radical reform of labour market rules, with the aim of clinching a deal next week.

There are a number possible potholes for the euro zone’s new fiscal pact not just in France — an Irish referendum (they’ve lost those before), signs of the Dutch governing coalition splintering over the issue as well as Francois Hollande’s vow to renegotiate it for France. And Germany has not yet dropped its opposition to a larger bailout fund and now faces complicated regional elections.

Even if all the stars are aligned, Italy, Spain, Portugal (let alone Greece) face years of economic hardship before the reforms bear fruit and cuts are finished with. The ECB’s wall of money and the likelihood that a strong euro zone firewall will be in place by mid-year have clearly reduced the existential threat to the currency bloc substantially. But so much of this is to do with market sentiment, currently benign, that it’s not hard to construct a scenario later this year where it could sour again.

While Greece is now firmly in election mode, on Monday the default insurance taken out on Greek bonds will be settled. It looks like around a net $2.5 billion will be paid out, not remotely threatening in a systemic sense. The question is: Is there a bank out there with a horribly exposed position?

For now, for crisis junkies – which most of us have become – there’s a slightly unnerving calm taking hold.
Markets, having gorged on central bank cash, are firmly in glass-half-full mode, maybe three-quarters full. The three big disaster hedges – gold, AAA debt and volatility indices – are all now in full retreat. On the other hand, stocks and other assets have rallied hard since the start of the year and can’t do that forever.

Indicative of the feeling that the euro zone crisis is in abeyance for now, the big event of the week is outside the currency zone: the annual UK budget.

With two ratings agencies floating the possibility of Britain being downgraded, finance minister George Osborne has plenty of cover to stick to his debt-cutting strategy, helped also by signs the economy may avoid a return to recession. Largely by dint of not being in the euro zone, Britain has been able to borrow at record low rates. The question is if investors were ever to conclude that the euro zone looked like a safer bet again, would that be the point at which they took a substantially dimmer view of the UK.

Britain still has clear advantages – its own currency and a central bank willing to print vast amounts of money, although who knows what problems that might store up for the future. The budget is not expected to show a great shift in the economic outlook from November’s autumn statement, when the growth forecast was sharply  downgraded.

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