100-years of solitude in the euro zone

February 14, 2013

The euro zone slipped deeper into recession than economists expected in the fourth quarter of 2012 as Germany and France– the region’s two largest economies – shrank 0.6 percent and 0.3 percent respectively on a quarterly basis.

The data is a reminder of the plight still facing the euro zone as it struggles to shake off a three-year debt crisis, which the region has sought to fight with harsh, growth-crimping austerity.

The European Central Bank’s promise to buy the bonds of struggling sovereigns has spurred investors back into those markets and helped reduce borrowing costs. While one trillion euros of cheap funding made available to banks in late 2011 and early 2012 also gave investors greater confidence, the benefits of such policies have yet to translate into improvements in the real economy.

According to David Schnautz, interest rate strategist, at Commerzbank:

The gap is still widening between what the market is pricing in and what the real economy or the overall situation actually justifies. The Spanish Q4 GDP number was a very nasty reminder that things are still in the doldrums there.

Spain, the euro zone’s fourth largest economy, released figures two weeks ago which showed it remained mired in recession after a 0.7 percent contraction in the fourth quarter. Data this week shows Italy’s GDP fell by 0.9 percent – its sixth successive quarterly fall.

Despite this, Spanish and Italian yields have fallen by well over 200 basis points since late July – when ECB President Mario Draghi first alluded to its plans by saying the central bank would do whatever it takes to protect the euro.

Alessandro Giansanti, senior rates strategist at ING, says Spanish and Italian bond markets are vulnerable to a sell-off regardless of the ECB support:

The support acts at the first stage, but then you need confirmation of positive news from the fiscal side and the macro side to support the trend.

Political uncertainty in Italy and Spain forced a pause in the six-month peripheral bond rally as Spanish Prime Minister Mariano Rajoy faced calls to step down over a corruption allegations against his party and as jitters set in before Italian elections on Feb. 24-25.

Even so, the correction has been limited, with Spanish and Italian yields only rising some 20 basis points since late January. This has worried some investors who fear markets could be mispricing risk again.

According to Richard McGuire, senior fixed income strategist at Rabobank:

We do appear to be in this zone where we are partying like it’s 2006.  Previously it was private sector liquidity that was the principle driver of investors paying insufficient heed to risk. This ultimately led to imbalances and bubbles being built up that led to the crisis. The solution to the crisis is more of the same sickness, except it’s public sector liquidity now.

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Lots of liquidity is floating around Europe, too. Courtesy of ELA, LTRO, OMT and probably a few other entries in the alphabet soup of ECB programs that I am neglecting.

This cheap money works the same way in Europe as it does in the United States. Large entities with access to these funds like banks, corporations, governments and rich people do very well as we can see by the rising stock market.

If you are a European worker, the situation is becoming more dire by the day:


This is the Cantillon effect in action. Cheap money flows to the rich, and they have themselves a good, old-fashioned economic boom. In the meantime, zombie companies are allowed to continue their existence due to cheap financing. The market never clears the companies out of the way so that new growing, enterprises never materialize creating economic growth.

Sometimes, I think that the price we will pay for all of this monetary manipulation is not a catastrophic crash but years of stagnation, like Japan.


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