This week in the euro zone

April 2, 2012

A new quarter dawns and although a holiday-shortened week isn’t likely to see dramatic investment decisions taken, the burning question is whether the strong ECB-fuelled rallies of the first three months of the year can continue. The consensus so far is yes, but at a more modest pace.

Markets will pick through the details of the Spanish budget and the euro zone’s decision on increasing the capacity of its firewall. Implementation risk in the first case, and shallow ambition in the second leaves scope for disappointment.

The standout events of the week are the policy meetings of the European Central Bank and Bank of England. No policy changes will result but within the former at least, there is growing internal debate about the long-term consequences of creating a trillion euros of three-year money which no doubt prevented a credit crunch, but according to monetarist theory at least, will inevitably fuel future inflation. There is also the conundrum of creating banks forever reliant on central bank support rather than being able to stand on their own two feet and start lending to each other again.

Bundesbank chief Jens Weidmann has been leading a push by a group of ECB policymakers for the bank to prepare for a shift to exit mode just a month after it completed the second of the lending operations. His ECB boss, Mario Draghi, is more relaxed and it is highly unlikely that the ECB will change course for several months yet and quite possibly not this year.

That applies in spades to the Bank of England. BoE Governor Mervyn King sat firmly on the fence last week, saying he did not know whether more QE would be required in Britain or not. King illuminated the other common theme coming from central bankers, saying the onus was firmly on the politicians now. The major western central banks seem to be in a holding pattern, disinclined to provide yet more stimulus yet viewing their economies as far too fragile to hit the policy reverse switch.

For investors pondering whether they could be derailed by a burgeoning economic slowdown, euro zone and UK purchasing managers’ indices – which have a strong correlation with GDP – will be a must-watch as will equivalent reports from China.
Spain will hold a pre-Easter bond auction. The glut of ECB money has helped Italian and Spanish debt sales go down a storm in the first quarter of the year – banishing the fear about their refinancing mountains – and that effect is likely to persist for some time yet, though not forever.

The ECB’s dramatic intervention and the debatable move by euro zone leaders to create a more potent rescue fund from mid-year buys time, but no more than that, for governments to push through structural reforms to make their economies more competitive and balance the need to cut debt while not snuffing out growth, a balancing act that has not been achieved so far. Until that is done, the underlying fault lines remain.

And ongoing political wrangling over budget cuts in recession-mired Netherlands shows this is not simply a southern European problem.

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