MacroScope

If Reuters polls onthe euro zone this year have proved anything, it’s that forecasts concerning the future of the currency union really boil down to national bias and not just plain economics.

Last week’s global polls of fund managers proved that’s just as true of investors as it is for analysts.

It’s a well-established trend: economists working for institutions based inside the euro zone are far more optimistic about its future than those from Britain or the United States.

While that might not sound surprising, it somewhat undermines the idea their analyses are based purely on economics, and less on national perspective.

Fund managers, who control trillions of dollars (and euros) in assets, are just as prone to this sort of bias.

Having not enjoyed a summer lull for a good few years, we might as well take advantage of this one which appears set to last for another couple of weeks yet (famous last words).

European Central Bank President Mario Draghi’s pledge to do whatever it takes to save the euro zone continues to underpin markets who view a litany of grim economic evidence as increasing the likelihood of further central bank action, not just from Europe but China and the United States too, thereby leaving them somewhat becalmed. (Remember the Greenspan put?)

The ECB chief’s intervention remains strictly in the realms of the rhetorical for now. The proof will come in September at the earliest – an ECB policy meeting in the first week is likely to set out the parameters as to how it might act to lower Spanish and Italian borrowing costs, a week later the German constitutional court rules on the viability of the euro zone’s permanent rescue fund, then euro zone finance ministers gather in Cyprus for a key meeting. Also in September, the troika of Greek lenders will return to decide whether Athens has done enough to secure its next bailout tranche.

Sometimes, a week away from the fray can bring perspective. Sometimes, you miss all hell breaking loose.
My last day in the office saw European Central Bank President Mario Draghi utter his “we will do whatever it takes” to save the euro declaration. The markets took off on that, only to sag when the ECB didn’t follow through at last Thursday’s policy meeting.

In fact, it was never that likely that the ECB would rush to act, particularly since Draghi’s verbal intervention had started to push Italian and Spanish borrowing costs lower and the troika of lenders was still musing over Greece. But it seems to me that, despite German reservations, the ECB president has shifted the terms of trade, something market action is beginning to reflect.

There can be little doubt now that the ECB will intervene decisively if required – and the removal of that doubt takes away the main question that has kept markets on edge every since a bumper first quarter evaporated. Yes, there are caveats – notably the fact that Draghi said the ECB would only step in if countries first request assistance. With that will come conditionality and surveillance but it seems highly unlikely that Spain, for example, will be required to come up with any further austerity measures given what it is already doing. Spanish premier Rajoy seemed to soften Madrid’s opposition to seeking help last week, though he said he wanted to know precisely what the ECB might do in return. Until now, seeking sovereign aid has been a taboo for Spain. If that’s changed, it’s also big news.

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?

Moody’s put Germany on notice that it might cut its credit rating and did the same for the Netherlands and Luxembourg. It cited a growing chance that Greece could leave the euro zone, and the contagion and costs that could flow from that, as well as the possibility that Berlin might have to increase its support for Italy and Spain. Both are self-evident risks and markets have not really reacted though it’s interesting timing that Spanish Economy Minister de Guindos is meeting his German counterpart, Wolfgang Schaeuble, in Berlin later. The Moody’s warning could also feed into darkening German public opinion about the merits of offering any more help to its sick partners.

German Bund futures opened just 10 ticks lower and European stocks edged higher after a sharp Monday sell-off. A jump in China’s PMI index has helped sentiment a little. The euro remains on the back foot but if it continues to fall that should actually help euro zone economies, making their exports more competitive. We’re programmed to treat government statements with scepticism but it’s hard to argue with the German finance ministry which said last night that the risks cited by Moody’s were nothing new and the sound state of German public finances was unchanged.

Nonetheless, reminders of the depth of the debt crisis are close at hand. So dislocated is the Spanish debt market that is hard to gauge what costs Spain will be required to pay at today’s T-bill auction because a combination of summer holidays and worries about the country’s finances mean trading has virtually dried up. With benchmark bond yields hitting euro-era highs on Monday, however, the debt sale of 3 billion euros in 3- and 6-month bills is likely to be expensive.
Also last night, clearing house LCH.Clearnet SA  increased the cost of using Spanish and Italian bonds to raise funds via its repo service, which could put further upward pressure on already surging yields.

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.

Spain will auction up to three billion euros of a mixture of debt having enjoyed sharply lower borrowing costs at a T-bill auction earlier in the week. However, with 10-year yields still perilously close to 7 percent, it’s pretty clear that the latest austerity drive by Prime Minister Mariano Rajoy – which will take 65 billion euros out of the economy by the end of 2014 – seems to have achieved little more than settling the bond market slightly.

All the efforts of the past few weeks – the bank bailout, the fresh austerity measures and the leeway on deficit targets from the euro zone – appear aimed at keeping a full Spanish sovereign bailout at bay. But it’s quite possible that all these efforts are actually hastening a full bailout rather than warding it off by driving Spain deeper into recession and cutting state revenues.  That is something the euro zone rescue funds with a maximum of 500 billion euros at their disposal, 100 billion of which is earmarked for Spain’s banks, cannot really afford.
We’ll get the final, firm details of the Spanish bank rescue on Friday.

Secondary markets prices suggest the yields on the two-, five- and seven-year bonds will all rise from the last time these maturities were sold and Spain’s advantage of having front-loaded debt issuance in the first half of the year has evaporated as looser deficit targets agreed with Brussels and Madrid’s commitment to help its debt-laden regions have added more than 20 billion euros to the amount it thought it would have to raise in 2012.

Greece announced late yesterday that it would need a bridging loan to tide it over until it finds the nearly 12 billion euros of spending cuts demanded by the EU/IMF/ECB troika of inspectors, after which the next tranche of bailout money can flow, probably in September. The troika is due to return next week. There’s no doubt Athens will get the interim money. Jean-Claude Juncker, who chairs the group of euro zone finance ministers, said last week that nobody should fret about Greece’s finances in August. They would be shored up.

Today, Finance Minister Yannis Stournaras is expected to put a draft list of cuts to the leaders of the three parties comprising the country’s ruling coalition, who are rather hemmed in by pledges to voters not to fire civil servants and shun sweeping pensions and public sector wage cuts.

Italian Prime Minister Mario Monti threw in a curve ball last night, saying there was a real prospect that the autonomous island of Sicily could default. It accounts for about 5.5 percent of Italian GDP so shouldn’t wreck the country’s finances but it’s not a step in the right direction. If Italy’s debt mountain of 120 percent of GDP started rising rather than falling, it could be taken very badly by the markets.

Markets were a little unnerved yesterday by concern that Germany’s top court may take a long time to rule on complaints lodged against the euro zone’s permanent bailout fund, the ESM, which was supposed to come into effect this week. Finance Minister Schaeuble urged the constitutional court to reach a speedy decision. The judges are not expected to block it but Germany’s president says he won’t sign it into law without the court’s go-ahead. A minor delay will pose no problem. A lengthier one could jolt investors.

The head of the court raised the possibility of a review taking take two to three months. That could create a dangerous vacuum though he stressed that was just one option. Schaeuble is just out again saying he hopes for a verdict before the autumn.

Bundesbank head Weidmann said even rapid ratification may not stop the crisis escalating further. With only a maximum 500 billion euros (100 billion of which is earmarked for Spain’s banks) at its disposal, the ESM looks ill-equipped to tackle the bond market head on. When the European Central Bank intervened last year to lower Italian borrowing costs it was spending 13/14 billion euros a week. And even then, it bought only temporary leeway.

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.