MacroScope

One trillion euros is a lot of money. And as we have previously noted on this blog it did a lot for stock markets early this year but not much for the real economy.

But recent bond auctions in the euro zone suggest the impact of two rounds of cheap 3-year ECB funding on the region’s struggling bond market may also be fading.

Italian three-year borrowing costs surged more than a full percentage point at an auction to 3.89 percent – its highest since mid-January.

Nick Stamenkovic, strategist at RIA Capital Markets says:

Clearly it shows investor appetite for Italian bonds even at the short end has diminished recently as the effects of the two LTROs (long-term refinancing operations) from the ECB dissipate.

That was not the only patchy bond sale recently. Italy’s one-year borrowing costs doubled at a sale of short-term bills on Wednesday and, just last week, Spain had to pay dearer to borrow through medium-term bonds.

So much for the lasting power of the ECB’s 1 trillion euros in cheap bank loans. Spain is again looking like a basket-case, more because of market dynamics rather than any particular policy misteps.

Many observers have praised Spain for its willingness to implement reforms. And yet the markets have another idea. The cost of insuring debt issued by Spanish banks against default has risen sharply over the past month, as a tough budget this week did little to soothe concerns over the country’s deteriorating fiscal situation.

Default insurance for Santander is up 52 percent since March 1 to 393 basis points and the equivalent for BBVA jumped 54 percent over the same period. Both Spanish banks underperformed the Markit iTraxx senior financials index – which measures Europe’s financial institutions’ insurance, or credit default swap prices. It rose by 20 percent over the same period.

It was not a good day for Spain.

The euro zone’s fourth largest economy had to pay dearer to borrow through medium-term bonds, a sign that concerns over the country´s fiscal problems was curbing appetite for its debt. It sold 2.6 billion euros of 2015, 2016 and 2020 paper – at the low end of the target range.

In contrast, Portugal’s 1 billion euros sale of 18-month treasury bills was a successful test of market appetite for the longest-dated debt since it took an international bailout. Appetite for short-dated paper has been especially supported by the one trillion euros of cheap three-year European Central Bank funding injected into the financial system since December.

The problem is that Spain is the latest country to come into the firing line of the euro zone debt crisis. This week’s tough budget was not enough to calm investor nerves and many fear too much austerity could choke an already struggling economy where unemployment rose to a staggering 22.9 percent in the fourth quarter of 2011 – the highest in the European Union. Meanwhile, the government expects Spain’s public debt to jump in 2012 to its highest since at least 1990.

A new quarter dawns and although a holiday-shortened week isn’t likely to see dramatic investment decisions taken, the burning question is whether the strong ECB-fuelled rallies of the first three months of the year can continue. The consensus so far is yes, but at a more modest pace.

Markets will pick through the details of the Spanish budget and the euro zone’s decision on increasing the capacity of its firewall. Implementation risk in the first case, and shallow ambition in the second leaves scope for disappointment.

The standout events of the week are the policy meetings of the European Central Bank and Bank of England. No policy changes will result but within the former at least, there is growing internal debate about the long-term consequences of creating a trillion euros of three-year money which no doubt prevented a credit crunch, but according to monetarist theory at least, will inevitably fuel future inflation. There is also the conundrum of creating banks forever reliant on central bank support rather than being able to stand on their own two feet and start lending to each other again.

Ireland, hailed as the poster child of euro zone austerity, is hoping to get back into the long-term bond market this year. But analysts say a hasty return could do more harm than good.

Its market position has certainly improved since it was pushed out of commercial markets and forced to seek a bailout, even though the population at large is still struggling with rigorous austerity.

Ten-year Irish yields have halved to just below 7 percent since July – before the European Central Bank began buying Spanish and Italian bonds in the secondary market to stabilise peripheral markets.

The first quarter winds to a close and, for most investors, it must have been a profitable one with stocks climbing and peripheral euro zone bond yields falling largely on the back of the European Central Bank’s efforts to pump prime the financial sector with a trillion new euros. Reuters’ asset allocation polls on Tuesday will look at whether there has been a significant pull-back from core government debt and the “risk on” trend can continue.

The second quarter may be much less straightforward (though let’s not forget at the turn of the year, no one thought the first quarter would be either) but let’s not get too far ahead of ourselves.

The coming week provides a number of chances to take the temperature of the euro zone debt saga. Spain, having ripped up its 2012 deficit target, will present its full budget a day after a general strike and EU finance ministers gather in Copenhagen where the still unresolved issue of how to structure the euro zone’s permanent rescue fund will be structured.

The financial turmoil still dogging Europe is most often described as a debt crisis. But sovereign debt is only part of the problem, according to new research from Jay Shambaugh, economist at Georgetown’s McDonough School of Business. The other two prongs of what he describes as three coexisting crises are the region’s troubled banks and the prospect of an imminent recession.

These problems are mutually reinforcing, and require a more forceful policy response than the authorities have delivered to date. In particular, Shambaugh advocates using tax policy to lower labor costs, fiscal stimulus from those economies strong enough to afford it, and more aggressive action from the European Central Bank:

It is possible that coordinated shifts in payroll and consumption taxes could aid the painful process of internal devaluation. The EFSF could be used to capitalize banks and to help break the sovereign / bank link. Fiscal support in core countries could help spur growth.  Finally, the ECB could provide liquidity to sovereigns and increase nominal GDP growth as well as allow slightly faster inflation to facilitate deleveraging and relative price adjustments across regions.

If you have ever wondered why financial markets and economists are interested in purchasing managers indexes, here is why:

The spotlight swings firmly on to Italy where Prime Minister Mario Monti is meeting trade unions and employers in an attempt to push through labour reforms which he hopes will galvanise the economy. The largest union has said a deal is “impossible” by an end-of-week deadline despite signs the government is watering down the  measures.

This is big stuff. A number of key factors have helped move the euro zone debt crisis on from critical to chronic; top of the list was the ECB’s creation of a trillion euros of three-year money but not far behind came the elevation of Monti and the hope invested in him that he can turn the Italian economy around. If the euro zone’s fourth largest economy fell over, the currency bloc really would be on the skids. He must convince markets – which remain becalmed for now – that he can raise Italy’s trend growth rate if its 120 percent of GDP debt pile is ever to be eaten into.

If faith in the technocrat premier wanes, it could have a significant effect on currently benign investor sentiment towards the euro zone.

I don’t want to be the idiot who asked “is it all over?” … but is it all over?

Almost certainly not, is the answer. Greece is shored up for now but Portugal will probably need to follow it in seeking a second bailout and Spain, heading back into recession, will have to make deep, deep cuts over the next two years to meet EU deficit targets. Greek and French elections could easily upset the apple cart, the former producing a fractured government with less will to tread the austerity path, the latter a new president who wants to renegotiate the bloc’s new fiscal rules (though neither are guaranteed).

In Italy, a lot of faith continues to be placed in Monti but the proof of his ability to deliver the structural reforms needed to regalvanise the economy has yet to be seen. On that front, the Italian government is talking with trade unions during the week on radical reform of labour market rules, with the aim of clinching a deal next week.