MacroScope

Does the European crisis need to get worse to get better?

Europe will do what it takes to save the euro, after it tries everything else. That seems to be the conventional wisdom about the continent’s muddled handling of a financial crisis now well into its third year.

The latest whipsaw came this week when, having hinted at aggressive action on the part of the European Central Bank, its president, Mario Draghi, backtracked a bit by saying the ECB “may” take further non-standard measures such as purchases of government bonds of countries like Spain and Italy, which have come under extreme market pressure.

John Praveen, chief investment strategist at Prudential International Investments Advisers, notes Draghi appears to have attached a new condition to ECB bond buys. Those countries must first ask for a formal bailout from the European Union, which they are reluctant to do because of the tough austerity measures that would then be imposed on them.

The ECB tied its fresh measures to actions by national governments. Specifically, before the ECB reactivates the SMP and steps in to buy bonds on the secondary market (Spanish and Italian bonds), these national governments will first have to seek formal assistance from the ESM/EFSF (Eurozone’s government bail-out fund) to purchase their bonds. Following the request to the EFSF, the ECB will step in to buy bonds.

Unfortunately, at present, both Spain and Italy are very reluctant to seek EFSF support due to the onerous austerity and structural reform conditions that this would entail. Thus, it appears that the crisis (in Spain and Italy) has to worsen and borrowing costs rise further before these governments are forced to ask for EFSF help. Thus, the ECB is likely to standby until the crisis worsens.

Goldman thinks market’s disappointment with ECB is premature

Financial markets on Thursday were starkly disappointed with the European Central Bank and its president, Mario Draghi. He had promised recently to do everything in his power to save the euro and yet announced no new bond-buying at the central bank’s latest meeting. Riskier assets sold off and safe-haven securities benefitted.

But Francesco Garzarelli of Goldman Sachs, Draghi’s former employer, has a different take on the matter:

We see a material change in the central bank’s approach to the crisis, and a coherent interplay between fiscal and monetary policy. The underwhelming part of today’s announcements lies in the lack of details on the asset purchases and other measures to support the private sector. But it appears that these will have more structure around them than the SMP (Securities Markets Program).

U.S. bond bulls ready to charge after payrolls report, survey says

(Corrects to show CRT is not a primary dealer)

Bond bulls are ready to charge after Friday’s July U.S. employment data, according to a survey by Ian Lyngen, senior government bond strategist at primary dealer CRT Capital Group.

Says Lyngen:

Despite the vacation season and the multitude of ‘out of office’ responses we got, participation in this month’s survey was above-average and consistent with a market that’s engaged for the big policy/data events of the summer. As for the results of the survey, in a word: BULLISH.

Lyngen argued the survey results were the most bullish since November 2010, a point that was followed by a selloff that brought 10-year yields from 2.55 percent to 3.75 percent over the following four months.

Like over-hyped Olympian, Fed set to disappoint

Pity the Federal Reserve. Like an over-hyped Olympian, the U.S. central bank enters this week’s policy meeting with sky-high expectations and a high probability of disappointment.

Markets are salivating at the prospect of a decisive easing move when Fed policymakers emerge from their meeting on Wednesday. The S&P 500 is up 3.6 percent in the last four sessions as traders hold out hope the Fed will launch a third round of quantitative easing, or QE3, to blast the U.S. economy out of its funk. Stumbling job creation, manufacturing and spending, as well as a measly 1.5 percent GDP growth in the second quarter and serious spillover threats ahead from Europe’s debt crisis, all feed this thesis. Fed policymakers from Chairman Ben Bernanke on down the line to Cleveland Fed President Sandra Pianalto and James Bullard of St. Louis have also stoked the market with a more dovish tone the last little while. And yet, this is probably not the time for a big policy move.

Topping the list of reasons to disappoint – and to knock the market down to size – the Fed probably doesn’t want to front-run the July employment report that’s due on Friday, and which will give a fresh sense whether the spring-summer slump in the labor market is temporary or more permanent. Waiting until the Fed’s next scheduled meeting, Sept. 12-13, would give policymakers the added benefit of the August jobs report. And speaking of front-running, the U.S. central bank may not want to get out just ahead of the European Central Bank’s policy decision on Thursday. If, down the line, things get really ugly in Europe – or if the U.S. Congress sends the country off the so-called fiscal cliff – the Fed will probably want to have the QE3 bazooka ready in its arsenal.

Euro zone facing autumn crunch?

Spain remains the focus for the markets but here comes Greece racing up on the outside lane. Officials told us exclusively yesterday that Athens is way, way off the targets set by its bailout programme and a further restructuring will be needed. If so, it’s almost inevitable this time that euro zone governments and the ECB will have to take a hit. Are they prepared to? There’s little sign of it so far although a key ally of German Chancellor Angela Merkel said last night that a second haircut was an option.

CDU budget expert Norbert Barthle said Greece would do its level best to stay in the euro zone, and given the losses associated with its departure and the fact that it could also prove a tipping point for Spain, there are powerful reasons to hope that’s true. But, but, but it’s pretty apparent that Athens has little chance of delivering the cuts being asked of it without completely wrecking its economy even if it is cut a bit more slack. And the latter is a big “if” too. It’s hard to see Merkel telling the German public they are going to face another bill to keep Greece afloat. As Barthle said, a second debt write off “would cost us a lot of money”. He also flagged up another problem that has been aired in recent days – that the IMF would probably not stump up any more funds given Greece has not met its stipulations.

The euro zone has indicated it will keep Greece afloat through August while the troika of EU/IMF/ECB inspectors assess the situation but we could be approaching a crunch point in September or October and if we get there the big “contagion” question is back – would a full Greek default or euro zone exit (and by the way some policymakers have floated the possibility of allowing Greece to default within the euro zone because it would be slightly less chaotic) lead to a collapse of confidence in Spain?

A summer lull?

It seems foolish to hope for a summer lull given recent history but in euro zone debt crisis terms at least, the next week looks quieter unless the markets turn savage again.

That’s not to say things are getting better – Spain’s 10-year borrowing costs are still above the seven percent level which it cannot survive indefinitely — it’s just that things aren’t getting much worse at the moment. Certainly with the Spanish bank bailout signed off as far as it can be, there’s nothing on the policy front to shake things up for a while although the debt-laden region of Valencia’s call for help with its debt hardly inspires confidence that Madrid can get things back on track.

What there is next week is a welter of evidence coming up on the health, or lack of it, of the world economy.
Flash PMIs for the euro zone, France and Germany are swiftly followed by Germany’s Ifo sentiment survey and second quarter GDP figures from Britain. The Q2 U.S. growth figure also comes out on Wednesday as well as the Chinese PMI on Tuesday. The euro zone’s slide into recession is likely to be confirmed and of course Britain is already there and unlikely to clamber out despite government and central bank protestations that the country’s travails are all to do with the euro area.

Slow slow quick quick slow

Euro zone finance ministers meet later today to try and put flesh on the bones of the EU summit agreement 10 days ago. The trouble is there probably won’t be enough meat for markets which failed to rally significantly after the summit deal and are now unnerved by fresh signs of global slowdown.
Friday’s weak U.S. jobs report is the latest evidence to rattle investors so there is unlikely to be any let-up.

Spanish 10-year yields are back above seven percent. Madrid is fortunate not to face a heavy debt issuance month but August is a bit more demanding so time is short to turn things around. Italy’s Mario Monti said on Sunday the euro zone ministers must act now to lower borrowing costs and Spanish Prime Minister Mariano Rajoy more dramatically said the credibility of the entire European project rests here. He continues to do his bit, pledging on Saturday to produce further deficit-cutting measures, probably on Wednesday. They could include a VAT hike and cuts to public sector benefits.

The Eurogroup is unlikely to dramatically change the terms of trade. It has a lot on its agenda – the proposed bailout of Spanish banks of up to 100 billion euros, a much smaller bailout of Cyprus as well as firming up the summit agreement that the euro zone’s rescue fund should be tasked with intervening on the bond market to bring borrowing costs down and, once a cross-border banking supervision structure is in place (another highly ambitious plan which is supposed to take shape in an even more ambitious six months), to be allowed to recapitalize banks directly.

EU summit aftermath

After the EU summit exceeded expectations the more considered verdict of the markets will dictate in the short-term, certainly until the European Central Bank’s policy meeting on Thursday. Previous summit deals crumbled pretty quickly buying only a few days or even hours of market relief.

After strong gains on Friday, Asian stocks are up modestly and European shares have edged higher. However, German Bund futures are nearly half a point higher, so something’s got to give and more often than not it’s the stock market that thinks again. So maybe Friday’s rally was a one-off.

For it to have any legs, the ECB may well have to come up with something on Thursday, and a quarter-point rate cut – widely priced in – may not be enough. ECB policymaker Asmussen is already out saying Greece must should not loosen its bailout programme, Spain can restore confidence with a bank recap plan that builds in a large margin for error and dismissing calls for the ESM rescue fund, which comes into being next week, to get a banking licence so it could draw on virtually unlimited ECB funds. That all sounds fairly uncompromising.

Waiting for the summit

Cyprus became the fifth euro zone country to seek a bailout last night though its needs – maybe up to 10 billion euros – will not put a dent in the currency bloc’s resources. We’re still waiting to see precisely how much money Spain will take for its banks of the 100 billion euros offered. Moody’s cut the ratings of 28 of 33 Spanish banks by one to four notches last night, an inevitable consequence of the sovereign downgrade earlier this month.

Markets seems to have decided that they will be disappointed by the crunch summit at the end of the week. There was a somewhat discordant meeting between the big four euro zone leaders on Friday, with Germany’s Merkel refusing to budge in key areas, but she and French President Francois Hollande have the chance to strike a more positive note when they meet bilaterally on Wednesday abnd hot off the press we have a meeting of the finance ministers of Germany, France, Italy and Spain this evening — so maybe there is a concerted effort to get on the same page.

Lael Brainard, the U.S. Treasury guru who liaises with Europe, spoke for the rest of the world when she told us in an interview that EU leaders had to put “more flesh on the bone” of their ideas to resolve the crisis.

Law of diminishing returns

The law of diminishing returns?
The first euro zone bailout, of Greece, bought a few months of respite, the next ones bought weeks, latterly it was days. Now … hours. Spanish bond yields ended higher on the day and, more worryingly, Italy’s 10-year broke above six percent. It was always unlikely the deal to revive Spanish banks was going to lead to a durable market rally with make-or-break Greek elections looming on Sunday but there were other things at play.

Top of the list is that the bailout will inflate Spain’s public debt and the dangerous loop of damaged banks buying Spanish government bonds that are falling in value. There’s also the fact that Germany and others are keen to use the new ESM rescue fund to funnel money to Spain because of the greater flexibility it offers. That will make private investors subordinate to the ESM which could prompt another rush for the exits which Madrid can ill afford since this is the first euro zone bailout which keeps the recipient active in the bond market.
It’s for the same reason that a revival of the ECB’s bond-buying programme, which it still doesn’t fancy, could prove counter-productive.

Officials are already pondering that conundrum, suggesting that the loan to Spain could initially be made under the existing EFSF bailout fund then taken over by the ESM, though that sounds like the sort of creative thinking in Brussels that generally fails to convince investors.
Another cracking Retuers exclusive following our breaking of the Spanish bailout on Friday, showing European finance officials have discussed limiting the size of withdrawals from ATM machines, imposing border checks and introducing euro zone capital controls as a worst-case scenario should Athens decide to leave the euro, is unlikely to have settle market nerves.