MacroScope

Breaking with previous EU practice that depositors’ savings are sacrosanct, Cyprus and international lenders agreed at the weekend that savers would take a hit in return for the offer of 10 billion euros in aid.

Cypriot ministers are now scrambling to revise a plan to seize money from bank deposits before a parliamentary vote on Tuesday that will either secure the island’s financial rescue or threaten its default.

Whatever the final result, analysts say the genie is out of the bottle and the mere consideration of making savers pay for bailouts sets a dangerous precedent for the euro zone.

Toby Nangle, head of multi-asset allocation at Threadneedle Investments says the terms of the Cypriot bailout have introduced a levy on deposits as part of the euro zone crisis response toolkit:

The iniquity of exempting large and sophisticated government bond holders and senior bank bondholders from the bail-in, and instead designing it as a tax on depositors in such a way that deposit guarantees would not be triggered will lead to further erosion of trust between governments and their people. This is likely to contribute to the rise of anti-European politics across the European south. And the only thing that can defeat the European project is electoral anti-Europeanism.

Ten-year Spanish government bond yields hit their highest levels since the euro was created – above 7 percent – on growing doubts that the euro zone’s fourth largest economy will be able to avoid a full-blown sovereign bailout.

News that Spain’s heavily indebted eastern region of Valencia would ask Madrid for financial help reinforced concerns the country may eventually run out of funds. The rubber-stamping of a rescue package for Spain’s troubled banking sector did little to allay concerns.

Short-dated bonds came under particular pressure, flattening the Spanish yield curve further in a sign of mounting credit worries. Five-year bond yields hit a euro-era high of 6.928 percent, flirting with the widely dreaded 7 percent mark.

By Rahul Karunakar

The spread between 2- and 10-year U.S. Treasury yields will shrink to 180 basis points in a year according to the latest Reuters bonds poll – the narrowest margin since August 2008, the month before Lehman Brothers collapsed.

Historically, that spread has been a key indication of what investors and traders are thinking about the economy’s prospects: the narrower it gets, certainly with short-term rates already at rock bottom, the darker the outlook.

It wasn’t looking particularly good in August 2008, and of course we all know what happened the following month: the start of an epic financial and economic crisis the world is still struggling to shake off.

There’s a high degree of battening down the hatches going on before the Greek election by policymakers and market in case a hurricane results.

G20 sources told us last night that the major central banks would be prepared to take coordinated action to stabilize markets if necessary –- which I guess is always the case –  the Bank of England said it would  flood Britain’s banks with more than 100 billion pounds to try and get them to lend into the real economy and we broke news that the euro zone finance ministers will hold a conference call on Sunday evening to discuss the election results – all this as the world’s leaders gather in Mexico for a G20 summit starting on Monday.
Bank of England Governor Mervyn King said the euro zone malaise was creating a broader crisis of confidence.

The central banks acted in concert after the collapse of Lehmans in 2008, pumping vast amounts of liquidity into the world economy and slashing interest rates. There is much less scope on the latter now. The biggest onus may fall on the European Central Bank which may have to act to prop up Greek banks and maybe banks in other “periphery” countries too although the structures to do so through the Greek central bank are in place and functioning daily. In extremis, we can expect Japan and Switzerland to act to keep a cap on their currencies too. As a euro zone official said last night, a bank run might not even be that visible and start on Sunday night over the internet rather than with queues of people outside their local bank on Monday morning.

The ultra-low rates offered by two-year German bonds reflect just how worried investors have become about the euro zone debt crisis and the continent’s sluggish economy.

Two-year German debt is currently yielding only 0.09 percent. That is less than the 0.11 percent offered by equivalent bonds in Japan – whose central bank has been grappling with deflation for some two decades. It is also below the 0.26 percent offered by similar U.S. Treasuries after the Federal Reserve more than tripled the size of its balance sheet compared to pre-crisis levels.

Elwin de Groot, senior market economist at Rabobank, expects the euro zone’s sluggish economy and intractable debt crisis to continue to favour a safety bid as long as policymakers do not take steps towards a closer fiscal union. He sees the two-year German bond yield hitting zero in three to six months and ten-year benchmark yields falling to 1.40 percent over the same period from 1.59 percent currently.

Focus for the euro zone is firmly on Washington with G20 policymakers gathering ahead of the IMF spring meeting. The Fund is seeking an extra $400 billion-plus in crisis-fighting funds which, tallied with the $500 billion euro zone rescue fund about to be established, adds up to a meaningful firewall for the markets to ponder before they consider pushing Spain and Italy to the edge.

But as many sage minds are saying – U.S. Treasury Secretary Timothy Geithner among them – a firewall does not solve the root problems of the euro zone debt crisis. As our very own Alan Wheatley puts it, “It is not obvious why a stronger firewall should encourage anyone to enter a burning house”. Nonetheless, Reuters polling yesterday ascribed only a 25% and 13% chance respectively to Spain and Italy needing an international bailout.

If the IMF falls short, given the jittery mood in financial markets, that could be cue for a further sell-off. The IMF has pledges of $320 billion so far. The Chinese and British have yet to show their hands and the BRICS led by Brazil are demanding more power at the Fund before handing over extra cash. German Finance Minister Wolfgang Schaeuble told us earlier in the week that conflating those two issues was not acceptable so there is potential for a rift. The U.S. and Canada have already said they will provide no more funding. Finance ministers and central bankers from the Group of 20 advanced and emerging economies had dinner on Thursday night, ahead of a longer session on Friday.

So the debt crisis is back (did it ever really go away?) but it’s not yet anything like as acute as it was late last year.

Spain is coming under real market pressure, and dragging Italy with it to an extent, but there are good reasons to think it won’t fall over; banks well funded for now and the government’s savvy move to take advantage of benign early year conditions to shift almost half its 2012 debt issuance in three months.

Madrid faces another key test with a Thursday bond auction. Two weeks ago, it suffered its first wobbly debt sale for some months. The turning point is pretty clear – Prime Minister Mariano Rajoy’s decision to rip up Spain’s agreed deficit target for 2012 without consulting his partners. Since then, Spanish borrowing costs have soared though given the amount of debt Madrid has already shifted, that might not be as damaging as it was.

All eyes on Italy. After paying sharply higher yields to sell one-year paper on Wednesday, it faces the altogether trickier task of selling up to five billion euros of three-year bonds. Yields are expected to jump by a full percentage point from a month ago but, as with yesterday, demand will be there and the paper should get away.

German Bunds have opened flat and European stocks are set to edge up so the recent rush for the exits has at least temporarily abated.

After yesterday’s auction result, Italian officials were  quick to point the finger at “external factors” – code for Spain. That prompted Spain’s Mariano Rajoy to hit back, demanding European leaders choose their language with more care. The message from Madrid is that the government is doing everything asked of it on the austerity and structural reform front and needs stronger backing from its peers. It’s hard to argue with that. Italian premier Mario Monti has said similar about Italy. The difference is that he did not renege on an agreed deficit target without consulting Brussels.

Spanish 10-year bond yields are within a whisker of breaking above six percent for the first time since December and are dragging Italy’s up with them. The balmy days of first quarter calm are well and truly over. “Markets step up the attack”, El Pais blares from its front page this morning.

Spanish risk premiums have leapt since Prime Minister Mariano Rajoy defied Europe by unilaterally easing Madrid’s 2012 deficit target and investors seem to have lost faith again as the impact of the ECB’s massive liquidity injection begins to fade.

BUT, and there is a but, there are good reasons to believe Spain will not fall over in the way Greece and others have. One silver lining for Madrid is that it has taken advantage of the benign market conditions early in the year to clear almost half its 2012 debt issuance needs so rising secondary market yields may be less damaging than they were last year.
 
As usual, confidence is key. The ECB three-year money has not vanished. Look at the 800 billion or so euros deposited back at the ECB by banks every day and it’s clear that if sentiment improved some of that money could be put to use once again to buy Spanish and Italian bonds, though there’s no sign of that for now.
 
Markets are resolutely “risk off” although weak U.S. jobs data last week have a part to play here. European stock futures are flagging a further 0.5 percent loss following a 2.5 percent tumble on Tuesday. The most reliable euro zone barometer – the Bund future – has edged lower at the open, probably in anticipation of Germany auctioning a new 10-year bond later. Given the climate, it should be snapped up despite yields already at record lows: While Spain faces a 6 percent price to borrow for 10 years, Germany can do so for 1.6 percent.

After the Easter break, a bit of perspective — to paraphrase the immortal Spinal Tap, maybe too much perspective.

Over the past two weeks, Spanish and Italian borrowing costs have continued to rise – in the former’s case they have now relinquished more than half their fall since December and are heading back into the danger zone. Stocks have also appeared to have given up on their first quarter rally, presumably testament to the realization that the ECB and other top central banks are unlikely to be writing any more blank cheques for banks to reinvest.

Late last year, it was Italy that seemed to have the power to drag Spain into the debt crisis mire. Now, it’s the other way round and after the ECB anaesthesia  wears off, it’s clear the euro zone patient is still sickly.