MacroScope

Italy is expected to pay slightly more than it did a month ago to borrow for three years at today’s auction of up to 6 billion euros of a range of bonds. Yields edged up at a sale of 11 billion euros of short-term paper on Wednesday but there is no immediate cause for alarm. Three year-yields have dropped from 5.3 percent to around 3.3 since the ECB declared its readiness to buy the bonds of troubled euro zone sovereigns and Italy has shifted about 80 percent of its debt requirements this year, so is on track in that regard.

The fact that it now seems possible that Mario Monti could continue as prime minister after spring elections can’t do any harm either although yesterday’s surprise cut in income tax muddies the waters a little.

The main problem for Italy is that Spain is in no rush to seek a bailout, a move that would alleviate pressure on Rome too. The IMF kept up the drumbeat of pressure for action in Tokyo, demanding “courageous and cooperative action”, having yesterday said the euro area was still threatened by a “downward spiral of capital flight, breakup fears and economic decline”.  German Finance Minister Wolfgang Schaeuble retorted that Europe was solving its problems and had done far more than appeared to outside observers.

We’ve been reliably told that Germany wants Madrid to hold off for now. Angela Merkel faces an increasingly fractious Bundestag and she wants to go back to it only one more time with one package covering Spain, Greece and maybe bailouts of the small Cypriot and Slovene economies. Today, Merkel meets Hungarian premier Viktor Orban in Berlin.

Given all the mixed messages from the Spanish government it is entirely unclear that it has yet reconciled itself to seeking help, though its debt refinancing numbers still dictate that it will probably have to before the year is out. Overnight, Standard & Poor’s cut Spain to near junk and we’re still waiting for a Moody’s review, due any time, which could well push the sovereign into junk territory. S&P pointedly said the government’s hesitation over a bailout programme raised the downside risks to its rating. It also said tensions with regional governments were diluting policies. Prime Minister Mariano Rajoy may well want to get regional elections in Galicia and the Basque country, due later this month, out of the way before swallowing the bitter pill of outside help.

The IMF is ratcheting up the pressure on the euro zone again, telling it to deepen financial and fiscal ties as a matter of urgency to restore confidence in the global financial system. Despite the European Central Bank’s recent statement of intent, the Fund said the risks to financial stability had risen over the past six months and it raised its prediction of how much European banks are going to have to offload as part of a deleveraging process that has a long way to run.

An eye-watering $2.8 trillion of assets now needs to be cut over two years, which could further choke off credit to the currency bloc’s weaker members, deepen recessions and push up unemployment. Despite recent steps, the euro area is still threatened by a “downward spiral of capital flight, breakup fears and economic decline”.

Gloomy stuff and particularly noteworthy since the growing view in Europe is that on break-up fears at least, the ECB’s promise to buy sovereign bonds in unlimited amounts, once a country seeks help from the ESM rescue fund, had fundamentally turned a corner.

Euro zone finance ministers, apart from formally launching the ESM rescue fund, made little headway yesterday evening, holding what they called “robust” talks about Greece’s prospects but not coming up with anything to continue the pretence that the country can get back on track. The report from the troika of EU/IMF/ECB inspectors looks likely not to be complete until next month’s Eurogroup meeting.

There are signs of divisions between the euro zone and IMF, with the latter convinced only dramatic measures such as a big writedown on the Greek bonds held by European governments will make the numbers add up. “More needs to be done,” IMF head Christine Lagarde said pointedly last night.

Angela Merkel, who is visiting Athens today and could stir up public Greek anger by doing so, is apparently set on returning to her increasingly critical Bundestag just once more – with a sweeping package to deal with Greece, Spain, Cyprus and maybe Slovenia. Ergo, the lack of Greek progress means any Spanish move for aid is probably some way off. And given the chaotically mixed messages coming from Madrid, it’s not clear that the government there has fully realized it will have to do so at some point.

This morning, we exclusively report that Spanish Prime Minister Rajoy could be about to break another promise by freezing pensions and bringing forward a planned rise in the retirement age.

This latest austerity policy will be political poison at home but will give Madrid more credibility with its euro zone peers since that was one of Brussels’ policy recommendations for the country back in May. We know that at the end of next week the government will unveil its 2013 budget and further structural reforms which all smacks of an attempt to get its retaliation in first so that the euro zone and IMF won’t ask for any more cuts if and when Madrid makes its request for aid.

The pensions shift could well be kept under wraps until regional elections in late October are out of the way. It is less likely that the government can defer a request for help from the euro zone rescue fund, after which the ECB can pile into the secondary market, for that long given some daunting debt refinancing bills falling due at the end of next month.

Having done so with a t-bill sale on Tuesday, Spain will continue to try and cash in on the relatively benign market conditions created by the European Central Bank by selling up to 4.5 billion euros of 3- and 10-year bonds. It hasn’t tried to sell that much in one go since early March, when the ECB’s previous gambit – the three-year liquidity flood – had also imposed some calm upon the markets, albeit temporarily (there’s a lesson to be learned there).

Yields are likely to fall sharply from the most recent equivalent auctions but even so, it looks unlikely that Madrid can meet some daunting looking refinancing bills before the year is out, without outside help. Prime Minister Mariano Rajoy’s hesitation about making a request for bond-buying help from the ESM rescue fund, with the ECB rowing in behind, has already pushed Spanish 10-year yields back up towards six percent after a more than two-point plunge since ECB chief Mario Draghi issued his “I’ll save the euro” proclamation in late July.  They had peaked around 7.5 percent before that.

With the ECB having pledged to buy bonds if necessary, but only at the shorter end of the maturity scale, the three-year bonds should be snapped up. The 10-year issue may be a harder sell. The danger is that Spain (and Germany, which is saying Madrid shouldn’t take a bailout unless market pressure returns with a vengeance) dithers for so long that the positive sentiment created by Draghi dissipates completely.

After a tumultuous fortnight where the European Central Bank, U.S. Federal Reserve, German judges and Dutch voters combined to markedly lift the mood on financial markets, we’re probably in for a more humdrum few days, although a raft of economic data this week will be important – a critical mass of analysts are saying that after strong rallies, it will require evidence of real economic recovery, rather than crisis-fighting solutions, to keep stocks heading up into the year-end.

A weekend meeting of EU finance ministers reflected the progress made, but also the remaining potential pitfalls. Our team there reported the atmosphere was notably more relaxed and Spain’s announcement that it would unveil fresh economic reforms alongside its 2013 budget at the end of the month sent a strong signal that a request for bond-buying help from Madrid is likely in October. If made, the ECB could then pile into the secondary market to buy Spanish debt  if required and hopefully drag Italian borrowing costs down in tandem with Spain’s.

BUT. The Nicosia meeting also exposed unresolved differences between Germany and others over plans to build a banking union. German Finance Minister Wolfgang Schaeuble said handing bank oversight to the European Central Bank is not in itself sufficient to allow the euro zone’s rescue fund to directly assist banks – another key plank of the euro zone’s arsenal. It sounds like that debate went nowhere.
Having largely been the dog that hasn’t barked so far, public unrest is on the rise with big marches in Portugal and Spain over the weekend against further planned tax hikes and spending cuts.

Is everything falling into place to at least declare a moratorium in the euro zone debt crisis?

Well the ESM rescue fund getting a go-ahead from Germany’s consitutional court and the Dutch opting to vote for the two main pro-European parties, following Mario Draghi’s confirmation last week that the European Central Bank would buy Spanish and Italian bonds if required, means things are starting to look a little rosier.

The risks? Next spring’s Italian election, and what sort of government results, casts a long shadow and it is just about conceivable that Spain could baulk at asking for help, given the strings attached, although the sheer amount of debt it needs to shift by the end of the year will almost certainly force its hand. If the Bundesbank mounted a guerrilla war campaign against the ECB bond-buying programme it could well undermine its effectiveness. That is a big if given broad German political support for the scheme. Key countries remain deep in recession with little prospect of returning to growth because of the imperative to keep eating away at their debt mountains, which could eventually trigger a dramatic public reaction. France could well get dragged into that category.

Another blockbuster chapter in the euro zone epic.

Top billing today goes to Germany’s constitutional court, which is expected to give a green light to the euro zone’s permanent rescue fund, the ESM, albeit with some conditions imposed in terms of parliamentary oversight. The ruling begins at 0800 GMT. If the court defied expectations and upheld complaints about the fund, it would lead to the mother of all market sell-offs and plunge the euro zone into its deepest crisis yet.

Without the ESM, the European Central Bank’s carefully constructed plan to backstop the euro zone would be in tatters. It has said it will only intervene to buy the bonds of the bloc’s strugglers if they first seek help from the rescue fund and sign up to the strings that will be attached. The first rescue fund, the EFSF, could perhaps fill this role for a while but its resources are now threadbare, so without the ESM, markets would scent blood.

The Dutch go to the polls but with the hard-left Socialists seemingly losing support, the ruling Liberal party and moderate centre-left Labour are  neck-and-neck and look likely to form a coalition government committed to tight debt control and, more importantly, to the euro zone. So unless voters are lying to pollsters, some of the drama has leached out of this particular saga although it could take some considerable time to put a coalition together.

Despite Mario Draghi’s game changer, or potential game changer, the coming week’s events still have the power to shape the path of the euro zone debt crisis in a quite decisive way, regardless of the European Central Bank’s offer to buy as many government bonds as needed to buy politicians time to do their work.

The nuclear event would be the German constitutional court ruling on Wednesday that the bloc’s new ESM rescue fund should not come into being, which would leave the ECB’s plans in tatters since its intervention requires a country to seek help from the rescue funds first and the ESM’s predecessor, the EFSF, looks distinctly threadbare. That is unlikely to happen given the court’s previous history but it could well add conditions demanding greater German parliamentary scrutiny and even a future referendum on deeper European integration. For the time being though, the markets are likely to take a binary view. ‘Yes’ to the ESM good, ‘No’ very bad.

Dutch elections on the same day look to have been robbed of some of their potential drama with the firebrand hard-left socialists now slipping in the polls and the fiscally conservative Liberals neck-and-neck with the likeminded centre-left Labour party. But there are no guarantees and Germany could yet be robbed of one of its staunchest allies in the debt crisis debate.

After some perplexingly negative initial market reaction to the Draghi gambit everything turned around. European stocks leapt nearly 2.5 percent yesterday and Asian shares are set to bank their biggest daily gain in six weeks. Italian and Spanish borrowing costs have fallen markedly.

The fact that the ECB has set no limit on how many bonds it might buy marks this scheme out as very different to its predecessor but we’ve seen many false dawns before so it behoves us to keep an eye on what might prevent ECB President Mario Draghi drawing a line under nearly three years of debt crisis.

       1. Could Bundesbank chief Jens Weidmann, who remains strongly opposed, quit as his predecessor did last year? Very unlikely for now though there could be a later confrontation, on which more below. It was notable how many of Angela Merkel’s political lieutenants were deployed in public to back Draghi yesterday, although the German press have taken an altogether more negative view which could inflame German public opinion.