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.

One of two stories will probably emerge from Friday’s first reading on how the British economy fared at the end of last year.

If it shrank 0.1 percent in the fourth quarter as the consensus of economists polled by Reuters expects, or worse, we will hear it raises the disastrous spectre of a third recession in four years, or a “triple-dip”.

If it defies expectations by growing slightly, that risk is averted and the government will say it shows the economy is getting back on its feet.

Finally, finally, finally we get the much-vaunted David Cameron speech on Britain’s relationship with Europe.

So, what will Cameron say? Most bluntly he will promise a straight in-or-out EU referendum if he wins an election in 2015 and after he has negotiated a “new settlement”. He correctly notes that public disillusionment with Europe is at an all-time high, which is precisely why offering a referendum could lead to Britain leaving the bloc, something even Cameron doesn’t want, although he argues a vote could lance that boil.

A new EU must be built upon five principles, he says: competitiveness, flexibility, power flowing back to member states, democratic accountability and fairness. But there appears to be no detail on the powers he would attempt to claw back, after which he says he would campaign to stay in the bloc.

Financial conditions in the euro zone have significantly improved since the summer, when euro zone risks peaked because of German policymakers’ open consideration of a Greek exit, and the sovereign spreads of Italy and Spain reached new heights. The day before European Central Bank President Mario Draghi’s famous speech in London in which he announced that the ECB would do “whatever it takes” to save the euro, bond yields in Spain and Italy were at 7.75 percent and 6.75 percent, respectively, and rising. When the ECB announced its outright monetary transactions (OMT) bond-buying program, the euro zone was at risk of a collapse.

Since then, risks have abated significantly, thanks to a number of factors:

The ECB’s OMT has been incredibly successful in reducing the risks of breakup, redenomination and a liquidity/rollover crisis in the public debt markets of Spain and Italy. Although the ECB has yet to spend a single additional euro to buy the bonds of Spain and Italy, both short-term and longer-term sovereign spreads against German bonds have fallen substantially. Following a number of political and legal hurdles, the successful operational start of the European Stability Mechanism (ESM) rescue fund provides the euro zone with another €500 billion of official resources to backstop banks and sovereigns in the euro zone periphery, on top of the leftover funds of its predecessor, the European Financial Stability Facility (EFSF). Realizing that a monetary union is not viable without deeper integration, euro zone leaders have proposed a banking union, a fiscal union, an economic union and, eventually, a political union. The last is necessary to resolve any issue of democratic legitimacy that might result from national states transferring power from national governments to EU- or euro zone-wide institutions. This transfer of power also would have to involve the creation of such institutions to ensure solidarity and risk-sharing are developed in the banking, fiscal and economic unions. The open talk in the summer by some German authorities about an exit option for Greece has turned into a tentative willingness to prevent and postpone such an exit. There are several reasons for this. First, Greece has done some austerity and reforms in spite of a deepening recession, and the current coalition is holding up. Second, an orderly exit of Greece is impossible until Spain and Italy are successfully isolated. Such an exit would lead to massive contagion, which would hurt not only the euro zone periphery but also the core, given extensive trade and financial links. Third, an economic disaster in Greece would be damaging to the CDU Party’s chances of winning the German elections. Thus, even when Greece inevitably underperforms on its policy commitments, Germany and the troika (the IMF, EU and ECB) will hold their noses and keep the funds flowing as long as the current coalition holds up.

Given these developments, the risk of a Greek exit in 2013 has been significantly reduced, even if the risk of an eventual Greek exit from the euro zone is still high, close to 50 percent by my estimation. Meanwhile, the narrowing of Spanish and Italian sovereign spreads has significantly diminished the risk that either country will fully lose market access and be forced to undergo a full troika bailout like Greece, Portugal and Ireland. Both Spain and Italy may in 2013 opt for a memorandum of understanding (MoU) that opens the taps of ESM and OMT support, but such official financing would inspire confidence as it would not be associated with rising, unsustainable spreads and a loss of market access.

While there is a much lower likelihood of disorderly events in the euro zone, there are still significant obstacles to deeper integration, as well as country-specific economic and political vulnerabilities. The biggest obstacle to the formation of a banking, fiscal, economic and political union is that Germany is pushing back against the time line for action, with the initial skirmish on ECB supervision of euro zone banks. This backpedaling reflects deep German skepticism on whether the resolution of the euro zone crisis requires a move toward greater union. Without a more credible commitment to austerity and reforms from euro zone periphery countries, lurching forward would imply that risk-sharing will turn into a large, long-term transfer union, which is unacceptable to Germany and the core. Thus, Germany will do whatever is necessary to delay the integration process, at least until after elections in fall 2013.

After a long, long wait, Britain’s David Cameron is poised to make his big speech on his country’s future ties with Europe.

It was supposed to be delivered in the autumn but has been delayed as the realization has dawned that there is no obviously good outcome for the ruling Conservative party’s leadership which faces implacable eurosceptics within its rank-and-file, many of whom want out of the EU completely. Cameron almost certainly doesn’t want out but may be pushed in that direction if he cannot deliver the repatriated powers from the EU that he has suggested are possible.

It’s hard to see other European leaders playing ball, particularly since Cameron took the unusual step of wielding Britain’s veto at a summit just over a year ago. Whatever he says, a bout of internecine warfare in his party is quite possible on an issue that has ripped it apart before.

Spain doesn’t need financial help. That was the verdict from euro zone ministers on Monday – quickly followed by a selloff in Spanish stocks and bonds on Tuesday. The trouble with that line of thinking is that it again leaves policymakers behind the curve, reacting to events rather than preempting them, write currency strategists at Brown Brothers Harriman in a research note:

For several weeks now Germany Finance Minister Schaeuble has argued against the need for Spain to request aid. France and Italy, in contrast, have been reportedly encouraging Spain to ask for assistance, which they assume would ease financial pressures within the region as whole. The Eurogroup meeting of euro area finance ministers endorsed Schaeuble’s position. Spain is taking necessary measures to overhaul the economy, they said.  Spain is able to successfully fund itself in the capital markets. Aid is simply not needed now.

While there is a compelling logic to the argument, the problem is that it prevents officials from being proactive rather than continue to its reactive function. It means that whenSpaineventually requests assistance, it will be in a crisis and the cost of assistance will be greater. It is penny-wise but dollar foolish. By failing to find a preventative salve, officials are not maximizing the breathing space that the ECB has created (intentionally or otherwise).

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:

The euro zone economy may be doing far worse than most economists want to believe. That’s not good news for a central bank trying to rescue the single currency through a hotly-contested bond purchasing programme that has yet to get started.

The latest flash purchasing managers’ indexes, which cover thousands of euro zone companies, suggest the third quarter will mark the euro zone’s worst economic performance since the dark days of early 2009, according to Markit, which compiles them.

They predict the economy likely shrank by 0.6 percent in the quarter that finishes at the end of this month.

Mounting speculation that Spain is prepping for a bailout begs the question – what happens to Italy?

Sources told Reuters Spain is considering freezing pensions and speeding up a planned rise in the retirement age as it races to cut spending and meet conditions of an expected international sovereign aid package.

Markets took this to mean it was preparing the ground for eventually asking for help. According to Lyn Graham-Taylor, fixed income strategist at Rabobank:

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.