Euro zone ying and yang
The ying. Sources told us last night that Spain may recapitalize stricken Bankia with government bonds in return for shares in the bank. That would presumably involve an up-front hit for Spain’s public finances (it is already striving to lop about 6 percentage points off its budget deficit in two years) which might be recouped at some point if the shares don’t disappear through the floor. The ECB’s view of this will be crucial since the plan seems to involve the bank depositing the new bonds with the ECB as collateral in return for cash. If it cries foul, where would that leave Madrid?
Spain’s main advantage up to now – that it had issued well over half the debt it needs to this year – may already have evaporated after the government revealed that the publicly stated figure for maturing debt of the autonomous regions of 8 billion euros for this year is in fact more like 36 billion. Catalonia said late last week that it needed central government help to refinance its debt. If more bonds are required to cover some or all of Bankia’s 19 billion euros bailout, Spain’s funding challenge in the second half of the year starts to look very daunting indeed.
The yang. Latest Greek opinion polls, five of them, show the pro-bailout New Democracy have regained the lead ahead of June 17 elections although their advantage is a very slender one. If the party manages to hold first place, and secures the 50 parliamentary seat bonus that comes with it, then it looks like it would have the numbers to form a government with socialist PASOK which would keep the bailout programme on the road … for a while.
After a disastrous campaign first time around, maybe New Democracy has got its act together. Its leader, Antonis Samaras was out yesterday bluntly saying his anti-bailout SYRIZA opponents would leave Greece isolated for years and without food, drugs, fuel and power. Sobering stuff. Officials have already told us Greece will run out of money by July if outside money dries up.
Samaras is calling for Greece to be given four years rather than two to make the spending cuts demanded of it. PASOK’s Venizelos says it needs three. Could there be a deal to be done with Brussels and the IMF there? Maybe, but there does seem to be a distinct lack of sympathy from Athens’ international lenders. Over the weekend, IMF chief Lagarde effectively accused Greeks of being tax dodgers and said she was more concerned about the plight of deprived children in Africa. That caused a storm on her Facebook page, causing her to soften her tone a little. Germany’s interior minister chipped in, ruling out pouring money into a Greek “bottomless pit” and a senior Deutsche Bank executive said it was a failed state.
On the Greek exit contingency planning front, British interior minister Theresa May said work was under way to restrict immigration in the event of a financial collapse although she was later slapped down by deputy prime minister Nick Clegg. And the Lloyd’s of London insurance market said it had reduced its exposure “as much as possible” to the euro zone in preparation for a collapse of the single currency.
German Bund futures have slipped as a result of the latest Greek polls but traders said Spain was weighing heavily on the other side of the ledger. European stocks are up 0.7 percent.
Euro zone may struggle with its own Lost Decade
Additional Reporting by Andy Bruce and polling by Rahul Karunakar and Sumanta Dey.
As Europe’s crisis drags on, the prospect of a Japanese-style lost decade of economic malaise is becoming increasingly real, according to a new poll. Half of the bond strategists and economists surveyed by Reuters are now expecting just such an outcome.
Many market participants have dismissed the fall of two-year German bond yields below their Japanese counterparts as being merely a result of a crisis-fueled flight to quality bid. Two-year German yields are now close to zero, offering returns of only 0.02 percent. By contrast, equivalent Japanese bonds are yielding 0.11 percent.
But a significant portion of analysts in a Reuters poll see something more sinister in the rapid narrowing of the premium investors require to hold German debt over Japanese bonds. One half of those polled – 12 out of 24 – said it is likely the euro zone is close to entering a period of prolonged low or no growth and inflation and low interest rates, with the other half saying it was unlikely.
According to Stephen Lewis, chief economist at Monument Securities:
I don’t really see an early end to the financial crisis in the euro zone. I think it’s very unlikely that Germany and the other countries will see eye to eye in the course of this year. That’s going to keep the euro zone economy looking very weak for the next several quarters.
Europe’s economy stagnated in the first quarter of 2012 and is expected to shrink 0.4 percent this year, according to another recent Reuters poll. Data on Thursday certainly pointed in that direction, suggesting even wealthier countries like France and Germany are also starting to feel the pinch.
Germany’s zero bound
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.
Peter Allwright of investment management firm RWC Partners goes one step further. He can envision a scenario where the German Schatz trades at significantly negative yields as the crisis unfolds.
There is going to be a huge shortage of triple A collateral in euros and if people start to price in the euro break-up scenario, people are going to be pushed into that.
“There are human beings involved” in austerity debate
The inventors of democracy and its greatest 18th century champions both go to the polls this weekend. Greek and French voters will try to elect governments they hope will help release their economies from the grips of the euro zone debt crisis.
While exercising their democratic vote, Europeans will also be contemplating another key issue: their basic economic survival.
That is why the debate about austerity versus growth has become so important.
Financial markets see fiscal discipline as crucial to get the euro zone’s debt burden back to sustainable levels. They are going into the Greek elections favoring triple-A rated bonds over peripheral counterparts.
The premium investors require to hold French debt over German Bunds has also risen in the run-up to the French vote as Francois Hollande became the favourite to win.
But as economies fall deeper into recession and double-digit unemployment hurts prospects for growth, the view that austerity alone will not solve the euro zone debt crisis, seems to be gradually winning over some investors in the bond market – the heart of the crisis.
Sanjay Joshi, head of fixed income at London and Capital, says:
Dancing on the edge of a (fiscal) cliff
With hundreds of billions worth of stimulus measures set to expire on Jan. 1, investors are all too aware that the United States is hurtling toward what economists are calling “a fiscal cliff.” It’s just that most seem to think Congress will execute one of its typical last-minute, hairpin turns to avoid plunging the economy over the edge.
As Russ Koesterich, global chief investment strategist at iShares told Reuters recently, “people are worried but they feel some sort of fix will get done.” Certainly the equity and bond markets back him up: the S&P 500 is up a healthy 12.7 percent this year while benchmark 10-year Treasury yields remain pinned beneath 2 percent.
Ethan Harris at Bank of America-Merrill Lynch isn’t so sure. After all, we’re talking about the same group of politicians who nearly forced the United States to default last year and earned it a credit downgrade from S&P in the process. This time, Republicans and Democrats will have just seven weeks to stitch up a deal, and they’ll have to do it while the wounds inflicted by a brutally negative a presidential election campaign are still fresh.
At stake are about $240 billion in income, capital gains, dividend and estate tax cuts – the Bush tax cuts – that are scheduled to expire on Jan. 1, along with Obama’s $90 billion payroll tax cut. Also set to start next year will be the first round of a 10-year diet of automatic spending cuts totaling $1.2 trillion. These were triggered when a Congressional committee failed last year to agree on a long-term deficit reduction plan.
Harris is warning clients to prepare for the worst:
Absent new legislation, fiscal policy will tighten by more than 4 percent of GDP. Even if just half of the threatened tightening occurs, it would be a major shock to growth.
Financial markets may not even have to wait until 2013 to feel the sting. As Harris puts it:
Tumultuous euro zone week
A week where every facet of the euro zone debt saga will come from all angles.
The major events are the French presidential run-off and Greek general elections on Sunday, May 6. In the former case, a likely socialist Francois Hollande victory could cause some market jitters given his rhetoric about the world of finance. But we’ve looked at this pretty forensically and actually there may not be much to scare the horses. Yes he is making growth a priority (but even the IMF is saying that’s a good idea) yet his only fiscal shift is to aim to balance the budget a year later than Sarkozy would. And, contrary to some reports, he is not intent on ripping up the EU’s new fiscal rules. And of course, the bond market will only allow so much leeway.
If the two main Greek parties – PASOK and New Democracy – fail to win enough votes to govern together, they may have to turn to a fringe anti-bailout party which would put a big question mark over Athens’ ability to stick with the austerity terms demanded by its international lenders.
Even if fears about a hard Greek default or even euro exit result, the threat of contagion looks far smaller. With creditors already having taken a massive haircut, most non-Greek banks completely out or at least having written down anything they hold, a 500 billion euros rescue fund shortly in place and the IMF raising an extra $430 billion of its own, the power Greece has to start a domino effect in the euro zone is very much diminished.
Netherlands’ fractured political parties have managed to put together a budget deal in time to present it on deadline to Brussels on Monday but Spain remains far more a source of concern. Downgraded again, its borrowing costs have soared since the government loosened its 2012 deficit target in March. Data just out shows the Spanish economy has succumbed to recession again. Madrid will hold a bond auction on Thursday, as will France.
As we’ve been saying for a while, hopes that the ECB cavalry will ride to the rescue are wide of the mark, until and unless the crisis takes a distinct turn for the worse.
The European Central Bank holds its monthly meeting in Barcelona on Thursday. No policy change is expected and Mario Draghi will doubtless re-emphasise that by creating more than a trillion euros of three-year money, the ECB has bought time for governments and banks to put their own houses in order. There will be a strong focus on his latest call – for a “growth compact” – though it seems to focus mainly on structural reforms and some capital spending out of EU funds, i.e. nothing that the ECB has to get involved in.
A curate’s egg — good in parts
An action-packed weekend with both good and bad news for the euro zone, which may — net — leave its prospects little clearer.
Item 1: The IMF came up with $430 billion in new firepower to contain the euro zone-led world economic crisis, although some of the money will only be delivered by the BRICS once they have more sway at the Fund. Nonetheless, the figure at least matches expectations and could give markets pause for thought. The official line is that it is for non-euro countries caught up in the maelstrom but no one really believes that. If a Spain is teetering, IMF funds will be there. Together with the 500 billion euros rescue fund set up by the euro zone, there is still barely enough to ringfence both Italy and Spain if it came to it. But will it come to it?
Item 2: Socialist Francois Hollande came out top in the first round of the French presidential election and is now a warm favourite to win. Some fear that could weaken the Franco-German motor which must be humming smoothly if further crisis-fighting measures are to be convincing. Others say he is essentially a centrist who, either way, will be constrained by the realities of the euro zone situation. Domestically, his focus on tax rises over spending cuts and a slower timetable for cuts could drive up French borrowing costs. Attempts by Hollande and President Nicola Sarkozy to woo the substantial votes that went to the far right and far left could lead to some nerve-jangling campaigning messages for the markets to swallow in the run-up to the May 6 second round.
Item 3: The left-field event of the weekend was the collapse of the Dutch government over budget plans. The hawkish Dutch could now delay ratifying the EU’s new fiscal pact. Finance minister De Jager, a hardliner, promises to try and cobble together enough support in parliament for a tough budget but there is absolutely no certainty he will succeed. The standoff raises the prospect of a rating cut and an even smaller band of top-rated euro zone members. Early elections, and a period of limbo, are quite likely – a negative for the euro zone which could well balance out the progress made at the IMF. And polls suggest popular support for austerity is waning in even this “core” euro zone member.
The euro is on the back foot, getting limited support from the IMF deal, with looming Italian and Dutch debt auctions casting a long shadow. Safe haven German Bund futures are up at the open, French bond futures are down, which tells you something. Dutch debt will doubtless come under pressure. The main focus remains on Spain and Italy with the latter trying to sell a variety of debt through the week against an unfavourable backdrop. Concerns about Spain in particular are well justified but it is not yet close to the precipice. The banks are at the heart of the country’s problems and are carrying the biggest burden of bad loans since 1994. They will almost certainly need more capital at some point. On the other hand, the central bank points out that thanks to the ECB’s three-year money offer the banks have loaded up on cash to the extent that their funding needs are covered for this year, and maybe next too. Add to that the fact that Spain has shifted half its government debt issuance for 2012 in the first third of the year and it is clear it has some time to turn around market sentiment, which soured sharply when Madrid reneged on an agreed deficit target back in March.
The European Central Bank remains the key player. Weekly bond-buying data later on Monday are likely to show it remained inactive last week but with Spanish 10-year yields back above six percent, it’s a live issue again. Given the stiff opposition from Bundesbank chief Weidmann and others, who are actually pushing for an exit strategy from extraordinary measures, it is likely that things would have to get a helluva lot worse before the ECB would return to the fray.
IMF crisis funds: Why nobody really cares
With reporting from Steven C. Johnson and Nick Olivari
A lot of time and money is spent on high-profile multilateral gatherings like this weekend’s International Monetary Fund meeting in Washington. The central story this time is the Fund’s effort to raise more funds (no pun intended), which appears to have been successful as G20 nations committed more than $430 billion in new funds.
French Finance Minister François Baroin, speaking to reporters at a press briefing on the sidelines of the IMF meeting, greeted the news with optimism:
Clearly, the reinforcement of the IMF with more than $400 billion in new resources and its effects on confidence will contribute to financial stability in the euro zone.
Except that for investors, the main worry is the continued ability of Spain and Italy to keep funding their debts as borrowing costs rise. The IMF’s new so-called firewall is of little consequence to that immediate chain of events, although it does provide some marginal reassurance.
Robert Tipp, chief investment strategist at Prudential Fixed Income, says:
Spain: ¿Cómo se dice “contagion”?
It was not a good day for Spain.
The euro zone’s fourth largest economy had to pay dearer to borrow through medium-term bonds, a sign that concerns over the country´s fiscal problems was curbing appetite for its debt. It sold 2.6 billion euros of 2015, 2016 and 2020 paper – at the low end of the target range.
In contrast, Portugal’s 1 billion euros sale of 18-month treasury bills was a successful test of market appetite for the longest-dated debt since it took an international bailout. Appetite for short-dated paper has been especially supported by the one trillion euros of cheap three-year European Central Bank funding injected into the financial system since December.
The problem is that Spain is the latest country to come into the firing line of the euro zone debt crisis. This week’s tough budget was not enough to calm investor nerves and many fear too much austerity could choke an already struggling economy where unemployment rose to a staggering 22.9 percent in the fourth quarter of 2011 – the highest in the European Union. Meanwhile, the government expects Spain’s public debt to jump in 2012 to its highest since at least 1990.
And although Spain has already sold around 46 percent of this year’s planned issuance of long-term debt and therefore is in a favourable funding position compared to its peers, analysts worry it could become the next source of euro zone contagion. In the secondary market, yields on 10-year Spanish government bonds rose to their highest since January at 5.72 percent after the auction.
DZ Bank rate strategist Michael Leister says:
It was only a lukewarm auction. This shows that the LTRO (ECB’s long-term refinancing operation) effect is losing momentum and that Spain is having a much more difficult time.
Europe’s triple threat: bad banks, big debts, slow growth
The financial turmoil still dogging Europe is most often described as a debt crisis. But sovereign debt is only part of the problem, according to new research from Jay Shambaugh, economist at Georgetown’s McDonough School of Business. The other two prongs of what he describes as three coexisting crises are the region’s troubled banks and the prospect of an imminent recession.
These problems are mutually reinforcing, and require a more forceful policy response than the authorities have delivered to date. In particular, Shambaugh advocates using tax policy to lower labor costs, fiscal stimulus from those economies strong enough to afford it, and more aggressive action from the European Central Bank:
It is possible that coordinated shifts in payroll and consumption taxes could aid the painful process of internal devaluation. The EFSF could be used to capitalize banks and to help break the sovereign / bank link. Fiscal support in core countries could help spur growth. Finally, the ECB could provide liquidity to sovereigns and increase nominal GDP growth as well as allow slightly faster inflation to facilitate deleveraging and relative price adjustments across regions.
All these steps, especially if taken together in an attempt to treat the three crises holistically could substantially improve outcomes. At the same time, institutional reforms to create a true financial union and a common risk free asset could help both solve the current problems and reduce the connections of these crises in the future. Of course, politics, ideology, or additional economic shocks could all hinder improvement. The euro area is highly vulnerable and without deft policy may continue in crisis for a considerable amount of time.
