MacroScope

An IMF team will conclude its annual review of the French economy and hold a news conference this morning.

It’s a safe bet that the Fund’s prescription will be similar to that of the EU and most other interested observers – the two extra years France has been given by Brussels to meet its debt-cutting targets must be used to liberalise and reform its economic structures. That was certainly Angela Merkel’s message to President Francois Hollande last week and also implicit in the Franco-German position paper which is intended to lay the ground for an EU summit at the end of the month.

The paper apparently contained a string of concessions from Germany – such as accepting a full-time president of the Eurogroup of euro zone finance ministers and paving the way for the next stage of a European banking union by accepting a “resolution board” to deal with restructuring or winding up failed banks, although that would be based on national authorities not the central body advocated by the European Commission and European Central Bank.

But the real story is what Hollande signed up to in return. The smart money says he promised to deliver on labour and pension reforms which will be tough for his socialist allies to swallow. Without that, France’s gentle economic decline could continue until the Franco-German motor which has traditionally driven the European project, could become solely the German motor.

By apparently giving ground – although how much remains to be seen as EU negotiations continue – Merkel may have given Hollande the political cover to act. His irate response to the European Commission’s policy demands last week showed that more than anything else, he cannot afford to be seen to be bowing to the demands of others.

Let’s face it: “Gerxit” doesn’t roll of the tongue nearly as smoothly as a “Grexit” did. While Europe continues to struggle economically, fears of a euro zone break-up have receded rapidly following bailouts of Greece and Cyprus linked to their troubled banking sectors.

Mounting anti-integration sentiment in some of region’s largest economies, raise concerns about whether the divisive monetary union will hold together in the long run. Indeed, the rise of an anti-Europe party in Germany begs the question of what would happen if one of the continent’s richer nations decided to abandon the 14-year old common currency. Never mind that, viewed broadly, the continent’s banking debacle has actual saved Germans money so far.

Billionaire financier George Soros, has argued that Germany should either accept a closer fiscal union with its peers, including so-called debt mutualization – the issuance of a common Eurobond – or give up on the euro. Hans-Werner Sinn, head of Germany’s influential Ifo Institute, strongly disagrees, blaming the crisis on southern Europe’s “loss of competitiveness.”

It’s raining central bankers today which is well-timed after Federal Reserve Chairman Ben Bernanke dropped the bombshell that the Fed could take the decision to begin throttling back its money-printing programme at one of its next few policy meetings. If that’s the case, and it’s not yet a done deal, then it will be the Fed that will move first in that direction, presumably putting further upward pressure on the dollar and send financial markets into something of a spin.

European stock futures look set to open sharply lower – 1.5 percent or more down – buffeted by suggestions that the Fed could soon change tack. Safe haven German Bund futures have opened higher for the same reason, though in a much more measured fashion. One of Bernanke’s colleagues, James Bullard, speaks in London today. Another, Charles Evans, is in Paris.

The European Central Bank has never got into the realms of QE but it did produce the single most important intervention over the past three years. Ten months after his pledge to save the euro fundamentally changed the dynamics of the currency bloc’s debt crisis, ECB chief Mario Draghi returns to the scene of his game-changing promise – London – to deliver a keynote speech. Draghi does not speak until the evening but his colleagues – Weidmann, Noyer, Coeure, Liikanen and Nowotny – all break cover earlier in the day. Draghi has said the ECB is prepared to act further if the economy worsens, having already cut interest rates to a fresh record low this month and ECB chief economist Peter Praet said last night that its toolkit could be expanded if necessary. But what?

Spanish government bonds have had a good run since the European Central Bank said it would protect the euro last year. But some analysts say the threat of a rating downgrade to junk remains an important risk.

Credit default swap prices are discounting such a move, according to Markit. Spain is only one notch above junk according to Moody’s and Standard & Poor’s ratings, and two notches above junk for Fitch. All three have it on negative outlook.  Bank of America-Merrill Lynch says it sees a “high probability” of a sovereign rating downgrade in the second half of the year.

As the table above shows, a cut to sub-investment grade would prompt Spanish sovereign debt to fall out of certain indices tracked by bond funds, resulting in forced selling, which could drive Spanish borrowing costs higher.

Evidence that Europe’s austerity policies are not working was in ample supply this morning. The euro zone as a whole is now in its longest recession since the start of monetary union. France has succumbed to the region’s retrenchment. Italy’s GDP slump is now the lengthiest on record. And Greece, still in depression, shrank another 5.3 percent in the first quarter.

To understand why this is happening, Brown University professor Mark Blyth says it is necessary to forget everything you think you know about the euro zone crisis. The monetary union’s troubles are not, as often depicted, the result of runaway spending by bloated, profligate states that are finally being forced to pay the piper. Instead, argues Blyth, it is merely a sequel to the U.S. financial meltdown that started, like its American counterpart, with dangerously-indebted risk-taking on the part of a super-sized banking sector.

In a new book entitled “Austerity: The history of a dangerous idea,” Blythe writes that sovereign budgets have come under strain primarily because taxpayers of various nations have been forced to shoulder the burden of failed banking systems.

Are European bond investors looking for love in all the wrong places?

The premium bankers demand to hold various types of euro zone debt over that of Germany has recently come down. In normal circumstances, this might suggest markets are no longer discriminating between the risks associated with different member countries’ bonds. But analysts say the recent convergence is based on a precarious belief of ECB action rather than any real improvement in economic fundamentals.

Spain and Italy still offer a comfortable premium over Germany. But a narrowing in yield spreads that is being driven by a fall in the funding costs of Spain and Italy, rather than by a rise in German yields, gives reason for pause.

According to Lyn Graham-Taylor, fixed income strategist at Rabobank:

The fact there is almost no movement from Germany and a huge movement in peripherals is indicative to us of this convergence for the wrong reason.

“Reality is sticky.” That was the core of Adam Posen’s message to German policymakers on their home turf, at a recent conference in Berlin.

What did the former UK Monetary Policy Committee member mean? Quite simply, that the types of structural economic changes that Germany has been pushing on the euro zone are not only destructive but also bound to fail, at least if history is any guide.

Posen, who now heads the Peterson Institute for International Economics in Washington, argued Germany’s imposition of austerity on Europe’s battered periphery is the product of an instinctive but misguided fear of an inflation “ghost” that has haunted the country since the hyperinflationary spurt of the Weimar Republic in the 1920s and 1930s. However, Posen offers a convincing account of modern economic history that shows inflation episodes are rather rare events associated with major political and institutional meltdown — and not always around the corner.

It wasn’t just the Nikkei. Euro zone government bonds rallied following Japan’s announcement of a massive new monetary stimulus. That sent yields on the debt of several euro zone countries to record lows on bets that Japanese investors might be switching out of Japanese government bonds into euro zone paper, or might soon do so.

The Bank of Japan on Thursday announced extraordinary stimulus steps to revive the world’s third-largest economy, vowing to inject about $1.4 trillion into the financial system in less than two years in a dose of shock therapy to end two decades of deflation.

Austrian, Dutch, French and Belgian borrowing costs over ten years fell to record lows as investors piled into euro zone debt offering a pick-up over Germany. The bond rally was led by 10- and 30-year maturities after the BOJ said it would double its holdings of long-term government bonds.

Money markets largely braved Cyprus’s bailout saga last week, but figures showing liquidity conditions are tightening suggest sentiment may not be as resilient the next time around.

Data from CrossBorder Capital, an independent financial firm that specialises in analysing global liquidity flows, shows the euro zone saw its biggest capital outflow in March since late 2011 – around the time the ECB injected liquidity into the financial system.

Financial institutions and governments took a net $175 billion worth of bonds and stocks, on an annualised basis, out of the euro zone in March – the biggest outflow since $201.4 billion in December 2011, according to the data.

The problem of a “democratic deficit” that might arise from the process of European integration has always been high on policymakers’ minds. The term even has its own Wikipedia entry.

As Cypriots waited patiently in line for banks to reopen after being shuttered for two weeks, the issue was brought to light with particular clarity, since the country’s bailout is widely seen as being imposed on it by richer, more powerful states, particularly Germany.

Luxembourg has accused the Germans of trying to impose “hegemony” on the euro zone.  The country, whose banking system, like Cyprus’, is very large relative to the economy’s tiny size, fears that similarly harsh treatment could be imposed on its depositors.