MacroScope

It seems eons since the euro zone finance ministers’ meetings which made such a hash of the Cyprus bailout but they were only two months ago. Monday’s Eurogroup will be altogether less eventful with some of the gathering probably a little jaded having spent part of their weekend at the G7 outside London where the usual differences about growth versus austerity and banking reform were aired.

No one will be sorry for a more routine meeting and there are no icebergs on the horizon but the agenda is still a full one. Featuring will be the economic situation on the basis of the Commission’s latest forecasts, the state of play in Cyprus, the decision already taken to release more bailout money to Greece, the new steps taken by Portugal to fill the gaps in its budget after the country’s top court struck some measures out, a review of European Commission reports on what is ailing Spain and Slovenia and a broad discussion about the merits of the ESM bailout being allowed to recapitalise bank retroactively from next year.

Italy offers a range of bonds at auction worth up to 8 billion euros which should be snapped up given the European Central Bank’s underwriting of the euro zone and Japanese money coursing through the financial system.

Germany’s Economy Ministry publishes its monthly report and Finance Minister Wolfgang Schaeuble makes a speech, this ahead of Q1 GDP figures on Wednesday which are likely to show that of the bigger members of the euro zone club, only Europe’s largest economy returned to growth in the first three months of the year. The Bank of France has just forecast that the French economy will eke out growth of 0.1 percent in the second quarter.

Schaeuble, writing in the FT, has confirmed what we reported last week – namely that he wants a limited banking union based around cross-border supervision and only much, much later (never?) a bloc-wide system to deal with failing banks which he continues to insist will require treaty change. Build the timber frame first and the steel frame later, he says. Until then, euro zone countries would continue to deal with problem banks. This has the fortunate effect of preventing Germany from taking on liability for others but it’s nothing like the structure that was proposed last year and will continue to cause considerable angst elsewhere, not least France, Spain and the European Central Bank.

They’ve only been looking for it for a day but Cyprus’s Plan B has already taken on mythical status. A myth it might remain.

Ideas being floated include nationalizing the pension fund (back of the envelope calculations suggest that will raise less than a billion euros) and issuing bonds underpinned by future natural gas revenues (but no one is really sure how much they are worth). So to avoid default it still looks like the Cypriots may have to return to the bank levy they rejected so decisively in parliament on Tuesday, to raise the 5.8 billion euros the euro zone is demanding in return for a bailout.

Finance minister Sarris is still in Moscow hoping for some change out of the Russians and is out this morning saying discussions are ongoing about banks and natural gas.

It’s ECB day and it could be a big one, not because a shift in policy is expected but because journalists will get an hour to quiz Mario Draghi on the Italy conundrum after the central bank leaves monetary policy on hold.

To explain: The story of the last five months has been the bond-buying safety net cast by the European Central Bank which took the sting out of the currency bloc’s debt crisis. But now it has an Achilles’ heel. The ECB has stated it will only buy the bonds of a country on certain policy conditions encompassing economic reform and austerity. An unwilling or unstable Italian government may be unable to meet those conditions so in theory the ECB should stand back. But what if the euro zone’s third biggest economy comes under serious market attack? Without ECB support the whole bloc would be thrown back into crisis and yet if it does intervene, some ECB policymakers and German lawmakers will throw their hands up in horror, potentially calling the whole programme in to question.

In Italy, outgoing technocrat premier Monti is due to meet centre-left leader Bersani, the man still harbouring hopes of forming some sort of government. Whether he succeeds or not it seems unlikely that any administration can ignore the dramatic anti-austerity vote delivered by the Italian people.

The Greek government pulled it off last night, winning parliamentary approval for an austerity package which offers yet more deep spending cuts, tax rises and measures to make it easier and cheaper to hire and fire workers. But boy was it tight. With the smallest member of the coalition rejecting the labour measures, Prime Minister Antonis Samaras carried the day by just a handful of votes. The overall budget bill is expected to be pushed through parliament on Sunday.

So the show remains on the road and this government has shown more resolve than its predecessors which may buy it some goodwill from its lenders. Attention today turns to the monthly policy meeting of the European Central Bank, a key player in negotiations to put Greece’s debts back on a sustainable path.  Mario Draghi could well rule out taking a haircut on the Greek bonds it holds, something the IMF has pushed it and euro zone governments to do but which Germany and others won’t countenance.  However, the ECB could forego profits it has made on Greek bonds it bought at a steep discount. Those profits have to be funneled through national euro zone central banks and would only be realized when the bonds mature but it would still help.

Greece is set to get two more years to make the cuts demanded of it and EU economics chief Olli Rehn told us yesterday that lengthening the maturities on official loans to Greece and lowering interest rates on them could be done but a haircut was out. There is the possibility of a meeting of the Eurogroup Working Group (the expert officials who prepare for euro zone finance ministers’ meetings) but it seems less likely that a deal will be struck at next Monday’s Eurogroup meeting, with officials now giving themselves until the end of November to come up with something. There were suggestions that Washington had urged big decisions to be put off until after the presidential election. True or not, that roadblock is now out of the way.

Having done so with a t-bill sale on Tuesday, Spain will continue to try and cash in on the relatively benign market conditions created by the European Central Bank by selling up to 4.5 billion euros of 3- and 10-year bonds. It hasn’t tried to sell that much in one go since early March, when the ECB’s previous gambit – the three-year liquidity flood – had also imposed some calm upon the markets, albeit temporarily (there’s a lesson to be learned there).

Yields are likely to fall sharply from the most recent equivalent auctions but even so, it looks unlikely that Madrid can meet some daunting looking refinancing bills before the year is out, without outside help. Prime Minister Mariano Rajoy’s hesitation about making a request for bond-buying help from the ESM rescue fund, with the ECB rowing in behind, has already pushed Spanish 10-year yields back up towards six percent after a more than two-point plunge since ECB chief Mario Draghi issued his “I’ll save the euro” proclamation in late July.  They had peaked around 7.5 percent before that.

With the ECB having pledged to buy bonds if necessary, but only at the shorter end of the maturity scale, the three-year bonds should be snapped up. The 10-year issue may be a harder sell. The danger is that Spain (and Germany, which is saying Madrid shouldn’t take a bailout unless market pressure returns with a vengeance) dithers for so long that the positive sentiment created by Draghi dissipates completely.

Spain will auction up to three billion euros of a mixture of debt having enjoyed sharply lower borrowing costs at a T-bill auction earlier in the week. However, with 10-year yields still perilously close to 7 percent, it’s pretty clear that the latest austerity drive by Prime Minister Mariano Rajoy – which will take 65 billion euros out of the economy by the end of 2014 – seems to have achieved little more than settling the bond market slightly.

All the efforts of the past few weeks – the bank bailout, the fresh austerity measures and the leeway on deficit targets from the euro zone – appear aimed at keeping a full Spanish sovereign bailout at bay. But it’s quite possible that all these efforts are actually hastening a full bailout rather than warding it off by driving Spain deeper into recession and cutting state revenues.  That is something the euro zone rescue funds with a maximum of 500 billion euros at their disposal, 100 billion of which is earmarked for Spain’s banks, cannot really afford.
We’ll get the final, firm details of the Spanish bank rescue on Friday.

Secondary markets prices suggest the yields on the two-, five- and seven-year bonds will all rise from the last time these maturities were sold and Spain’s advantage of having front-loaded debt issuance in the first half of the year has evaporated as looser deficit targets agreed with Brussels and Madrid’s commitment to help its debt-laden regions have added more than 20 billion euros to the amount it thought it would have to raise in 2012.

Greece announced late yesterday that it would need a bridging loan to tide it over until it finds the nearly 12 billion euros of spending cuts demanded by the EU/IMF/ECB troika of inspectors, after which the next tranche of bailout money can flow, probably in September. The troika is due to return next week. There’s no doubt Athens will get the interim money. Jean-Claude Juncker, who chairs the group of euro zone finance ministers, said last week that nobody should fret about Greece’s finances in August. They would be shored up.

Today, Finance Minister Yannis Stournaras is expected to put a draft list of cuts to the leaders of the three parties comprising the country’s ruling coalition, who are rather hemmed in by pledges to voters not to fire civil servants and shun sweeping pensions and public sector wage cuts.

Italian Prime Minister Mario Monti threw in a curve ball last night, saying there was a real prospect that the autonomous island of Sicily could default. It accounts for about 5.5 percent of Italian GDP so shouldn’t wreck the country’s finances but it’s not a step in the right direction. If Italy’s debt mountain of 120 percent of GDP started rising rather than falling, it could be taken very badly by the markets.

Bit of a day coming up with the European Central Bank topping the bill. A quarter-point interest rate cut is widely priced in and the bank may also lower its deposit rate to try and encourage the banks that dump up to 800 billion euros back in its coffers every night to invest it in the real economy or even Italian and Spanish government bonds.

There is even some talk of a third round of three-year money printing but that looks premature. Yes, the ECB has acted in the past after euro zone politicians have shown some gumption (which last week’s summit still just about qualifies for) but the other part of that equation is that the currency bloc has had to be right on the brink. Spanish 10-year yields are back below 6.5 percent, still too high but not as acute as in recent weeks. There are not likely to be any hints that the ECB will revive its bond-buying programme, despite the urgings from Spain and Italy, nor is it likely to give any support to the idea of giving the ESM rescue fund a banking licence so it can borrow virtually unlimited funds from the ECB (a back door way of achieving the same result).

The risk for the markets is that the ECB does very little, which should not be discounted, and even if it does there’s a possibility of a “buy the rumour, sell the fact” scenario.

It’s well and truly a Spain day.
Its 10-year yields may have ducked back below the 7 percent pain threshold but Madrid’s auction of two-, three- and five-year bonds could still be tricky. It is only aiming to sell up to 2 billion euros and should manage to thanks largely to weak Spanish banks buying them up but the five-year bond is likely to command yields last seen in 1996.

After that, an independent audit of Spain’s stricken banking sector is due to be published which will give a guide as to how much of the 100 billion euros offered by the euro zone the banks need to take to be recapitalized. Madrid may then make a formal request for aid at a meeting of euro zone finance ministers later in the day. We’ve had from sources that the audit will say up to 70 billion euros is needed but Spain would be well advised to take more to try and convince markets that it has all bases covered.

The audit is expected to divide the banks into three groups: the weakest regional savings banks heavily exposed to bad property debts, a group of mid-sized banks which face temporary liquidity problems and two ‘good’ banks – BBVA and Santander – that won’t need any help.

Italy, rapidly moving centre stage after the euro zone’s failure to assuage markets with a 100 billion euros Spanish bank bailout, faces a crunch bond auction. Having paid four percent to borrow for a year yesterday, it is likely to fork out over five percent for three-year paper although the smaller than usual target of up to 4.5 billion euros means the sale should get away. It will also issue a smattering of 2019 and 202 bonds.

Technocrat prime minister Mario Monti’s honeymoon period is over with even some he would have considered allies decrying the slow pace of his reform programme. Already this week he has appealed to Italy’s fractious political parties for support in keeping the austerity show on the road.
Today, Monti hosts France’s Francois Hollande. They agree on a lot – the need for a stronger growth strategy, a banking union established sooner rather than later and a longer-term goal of euro zone bonds. Berlin, with the possible exception of the first goal, definitely does not.

Moody’s slashed Spain’s rating to just one notch above junk last night. The power of the ratings agencies to shock is significantly diminished but if Spain’s sovereign rating drops further, more of whatever non-Spanish bank private investors are left will be forced to head for the exits. Moody’s noted that the bank bailout will increase Spain’s debt burden and the dangerous of loop of damaged banks being the main buyers of Spanish government debt which is falling in value. It repeated its warning that euro zone ratings could be cut further if Sunday’s Greek election were to increase the chances of that country leaving the euro.