MacroScope

The euro zone slipped deeper into recession than economists expected in the fourth quarter of 2012 as Germany and France– the region’s two largest economies – shrank 0.6 percent and 0.3 percent respectively on a quarterly basis.

The data is a reminder of the plight still facing the euro zone as it struggles to shake off a three-year debt crisis, which the region has sought to fight with harsh, growth-crimping austerity.

The European Central Bank’s promise to buy the bonds of struggling sovereigns has spurred investors back into those markets and helped reduce borrowing costs. While one trillion euros of cheap funding made available to banks in late 2011 and early 2012 also gave investors greater confidence, the benefits of such policies have yet to translate into improvements in the real economy.

According to David Schnautz, interest rate strategist, at Commerzbank:

The gap is still widening between what the market is pricing in and what the real economy or the overall situation actually justifies. The Spanish Q4 GDP number was a very nasty reminder that things are still in the doldrums there.

Spain, the euro zone’s fourth largest economy, released figures two weeks ago which showed it remained mired in recession after a 0.7 percent contraction in the fourth quarter. Data this week shows Italy’s GDP fell by 0.9 percent – its sixth successive quarterly fall.

We’ve been saying for some time that while the immediate heat may be off the euro zone, therein lies a danger – that policymakers will relax their efforts to remould the bloc into a tougher structure that can withstand future crises, and possibly even allow this crisis to flare back into life.

Exhibit A has been the apparent backsliding on what we thought was a concrete plan to allow the euro zone rescue funds to recapitalize banks directly from next year, thereby removing the onus on highly indebted governments to do so. Over the weekend we got Exhibit B courtesy of a Reuters exclusive.

We reported that the European Central Bank had rejected Ireland’s solution to avoid the crippling cost of servicing money borrowed to rescue its failed banking system – debt servicing would amount to around 3 billion euros a year for the next 10 years. Dublin wanted to convert the promissory note into long-term bonds. The ECB decided last week that that crossed its red line of monetary financing.

Italy’s borrowing costs over ten years drew closer to five percent after a decision by Prime Minister Mario Monti to step down early left the country’s political future unclear, hurting riskier euro zone debt.

Monti said on Saturday he would resign once the 2013 budget was approved, raising questions over who will take the reins of the euro zone’s third largest economy at a time when it remains a focus of the region’s three-year debt crisis.

His announcement, potentially bringing forward an election due early next year, came after former prime minister Silvio Berlusconi’s party withdrew its support for the government — and Berlusconi himself said he would run to become premier for a fifth time.

Is the U.S.on the road to Greece, as some politicians have proclaimed?

Most economists say the comparison is nonsense. At a towering $15 trillion, the U.S. economy is not only the world’s largest, it is also more than 50 times the size of Greece’s. This gap makes any type of comparison difficult – it would be like analyzing trends in Maryland in relation to the entire euro zone.

Another key difference: Unlike Greece, the U.S. actually controls its own currency. That means a debt default is effectively impossible. This reality, coupled with strong monetary stimulus from the Federal Reserve, helps explain why U.S. bond yields remain near historic lows despite larger deficits.

Mark Weisbrot, co-director of the progressive Center for Economic and Policy Research in Washington, says a country’s interest burden is far more important than its total debt levels in determining the government’s ability to service it. He argued in a recent editorial:

Social Security should not be part of the current negotiations over the U.S. budget – that was the message from outgoing Treasury Secretary Timothy Geithner over the weekend. During a veritable tour of Sunday shows aimed at addressing negotiations surrounding the “fiscal cliff” of expiring tax cuts and spending reductions, Geithner told ABC News’ “This Week”:

What the president is willing to do is to work with Democrats and Republicans to strengthen Social Security for future generations so Americans can approach retirement with dignity and with the confidence they can retire with a modest guaranteed benefit.

But we think you have to do that in a separate process so that our seniors aren’t – don’t face the concern that we’re somehow going to find savings in Social Security benefits to help reduce the other deficit.

Another week, another Greek debt deal. Third time’s a charm, EU and Greek politicians assure us. Under the agreement, Greece’s international lenders agreed to reduce Greece’s debt load by 40 billion euros, cutting it to 124 percent of gross domestic product by 2020 through a package of steps.

Marc Chandler, head of currency strategy at Brown Brothers Harriman, points out “an under-appreciated twist to the plot”: the Greek deal has potential implications for other bailed out European states like Portugal and Ireland.

European officials adopted a principle of equal treatment under the framework of the EFSF. Essentially, this means that consideration given out to Greece applied to the other countries who receive EFSF assistance, namely Ireland and Portugal.

There are signs of headway from Athens where we have just snapped a government source saying the IMF accepts Greek debt is “viable” if it falls to 124 percent of GDP in 2020, rather than the 120 that it had previously decreed was the maximum sustainable level.. The source said fresh measures have been found to reduce debt to 130 percent of GDP by 2020, leaving another 10 billion euros to be covered.

At the latest failed meeting of euro zone finance ministers on Tuesday, we confirmed that the EU/IMF/ECB troika had calculated Greek debt would only fall to 144 percent of GDP in 2020 without further measures, meaning roughly 50 billion euros needed to be knocked of Greece’s debt pile. A report circulated at the meeting concluded (apologies for the number soup) that debt could only be cut to 120 percent of GDP in eight years if euro zone government agreed to take a writedown on their loans, which they will not do for now.

If the IMF will now accept 124 percent as a target that means 20 percentage points of GDP – about 40 billion euros – would have to be lopped off Greece’s debt pile. If they are now only 10 billion short, then measures amounting to 30 billion have been found. It’s hard to believe that could have come from the Greek side which has already slashed to the bone, so maybe some or all of the options we know are on the table — a Greek debt buyback at a sharp discount, lowering the interest rate and lengthening terms on the loans and the ECB foregoing profits on its Greek bondholdings – have been agreed to.

There are still plenty of macro factors to worry about around the world, but China seems to have dropped down the charts. Conversations with delegates at TradeTech Asia, the annual trading heads’ conference held in Singapore, revealed that the U.S. fiscal cliff, food inflation, geopolitical risks in the Middle-East and Europe all trumped China as the major risks out there for financial markets.

Last time this year China was public enemy #1 for investors. But according to the latest Bank of America Merrill Lynch Global fund managers’ survey confidence in the outlook for China’s economy has surged to a three-year high – a big turnaround from a year ago when the fear was that shrinking company profits, rising bad loans and weak global demand at a time of stubbornly high inflation would all add up to a “hard-landing” for the world’s second largest economy. The consensus opinion among economists now is that the worst is over and growth bottomed in the third quarter that ended in September.

Money has come back to the market too. Nine straight weeks of inflows have seen $3.2 billion pumped into China equity funds, according to EPFR, in the lead up to the 18th Party Congress where China’s new leadership was unveiled.  Hong Kong, still the main gateway for foreign investors into China, has seen optimism over China combined with the U.S. Fed’s third round of asset purchases lead to strong capital flows into the market. The territory’s monetary authority was forced to repeatedly intervene to defend the HK$’s peg against the US$ last month while the Chinese yuan is hitting fresh record highs.

It was kind of a big deal coming from the Federal Reserve Bank of New York’s influential president William Dudley. The former Goldman Sachs partner and chief economist has offered a fig leaf to those who say the problem of banks considered too-big-to-fail must be dealt with more aggressively. Some regional Fed presidents have advocated breaking up these institutions. But Dudley and other powerful figures at the central bank have maintained recent financial reforms have already laid the groundwork for resolving the issue.

At a gathering of financial executives in New York last week, Dudley said he prefers the existing approach of making it costlier for firms to become big in the first place. Still, he left open the possibility of tackling the mega-bank problem more directly:

Should society tolerate a financial system in which certain financial institutions are deemed to be too big to fail? And, if not, then what should we do about it?

Spain will not seek aid imminently, says Prime Minister Mariano Rajoy. And by imminently, he means, not this weekend. Just the latest twist in a European crisis plot that now sees Spain as its primary actor.

The focus on Spain’s reluctance to see foreign aid, a pre-condition for additional European Central Bank purchases of its bonds, is ironic given the country’s record of goading weaker counterparts into similar rescue packages earlier in the crisis.

To Lena Komileva, chief economist at G+ Economics, the saga is all too reminiscent of the hapless meanderings of Don Quixote. Komileva argues that the country’s latest budget announcement marks only the beginning of a deeper, almost circular plight: