The new reality

June 20, 2013

The Federal Reserve has spoken and the message seems pretty clear – unless the U.S. economy takes a turn for the worse the pace of money creation will be slowed before the year is out and it will be stopped by mid-2014.

That’s a fairly tight time frame, although interest rates won’t rise for some time after that, and it doesn’t take a crystal ball to see a further bout of market volatility is likely, centred again on emerging markets which could suffer big portfolio investment outflows as U.S. bond yields climb.

The markets certainly don’t seem confused, just alarmed. The German Bund future has plummeted by nearly a point and a half to its lowest point since February, mirroring the spike in U.S. Treasury yields. European stocks shed 1.5 percent at the start.

The good news, if anyone wakes up to it, is that the Fed must be increasingly sure that U.S. recovery is entrenched. Flash PMI surveys for the euro zone, Germany and France will give the latest snapshot of our region’s economic malaise and are unlikely to be as upbeat as the world’s largest economy.

There’s trouble in China too, where its PMI showed factory activity sliding to a nine-month low, increasing the chances of a sharp second quarter slowdown. Markets being what they are could view that as a cue for the PBOC to come in but either way it’s a gloomy report and in terms of sentiment, Bernanke has shifted the glass from half full to half empty.

Against that roller coaster backdrop, Spain and France both hold bond auctions with the benevolent bond market conditions of the first five months of the year well and truly gone.

Italian and Spanish borrowing costs fell for 10 months after European Central Bank chief Mario Draghi pledged to do whatever it takes to save the euro but have begun creeping up since Bernanke’s first intervention in late May. Italian bond futures have shed more than a point in early trade, suggesting a tough day for the euro zone periphery and a tricky time to be bringing debt to the market.

Both Spain and Italy have front loaded their funding for this year, so some of the pressure is off. Maybe France is the better test case. Its economy is flatlining, the government is railing against exhortations from Berlin and Brussels to speed up contentious labour and pension reforms and yet it can still borrow for 10 years at not much more than two percent. Madrid will sell up to four billion euros of a range of paper while Paris will try to shift up to nine billion euros of fixed-rate and inflation-linked bonds.

France’s major unions, as well as employer groups and government officials, will attend a two-day conference to discuss four upcoming economic reforms: 1) the pension system; 2) the job training system; 3) the unemployment benefit system; and 4) the public housing system. Late in the day, the INSEE statistics office will publish its quarterly economic outlook.

If the market volatility prompted by the Fed’s intervention, which has caused a more modest rise in peripheral euro zone borrowing costs than the carnage seen in emerging markets, does not calm soon investors may well start looking askance at the currency bloc’s high debtors again, pushing the bloc back into crisis mode.

Things will have to get worse than they are now but Greek coalition parties are at each other’s throats, Spain is deep in recession, the IMF has proclaimed Portugal’s public debt position to be fragile (it also said yesterday that while Spain has made progress, its struggling banks mean even less credit would flow into the economy) and Italy has declared it will make no more cuts although its deeper-than-expected recession is pushing its deficit up.

All that makes it doubly important that EU leaders make real progress on agreeing the structures of a cross-border banking union, including measures to restructure or wind up failing banks.

A meeting of euro zone finance ministers will pave the way for the following week’s EU leaders’ summit. Don’t hold your breath. The ministers will decide when and how their bailout fund can invest in a bank to save it from collapse, which should go some way to boost confidence in the bloc’s lenders. But its resources are limited and more ambitious plans floated last year to create a cross-border mechanism for dealing with failing banks seem to be completely off the table.

With the European Central Bank effectively underwriting the bloc’s governments with its bond-buying pledge, that would do the same for the financial sector.

The trouble is, not unreasonably, Germany does not want to fall liable for the failure of a bank in a weaker country. Instead, it is pressing for a “resolution board” involving national authorities to take decisions on winding up failed banks, which sounds like the onus would remain on governments to sort out their own banks rather than pooling risk which would convince investors that a proper backstop was in place. In other words, the “doom loop” of weak banks and sovereigns weighing on each other would be unbroken.

Berlin will certainly not budge before German elections in September. The big question is whether it will do thereafter.

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