Shifting euro zone sands
A telling moment. Before pretty much every showdown EU summit since the debt crisis exploded into life, the leaders of France and Germany have got together beforehand to agree a common strategy. It is a truism that the European motor only works efficiently when its two biggest powers are in accord.
This time, following the election of Francois Hollande as French president, there has been no such meeting. Instead he will talk with Spanish premier Mariano Rajoy in Paris before they head to the Brussels summit. There, Hollande will press for the currency bloc to start issuing joint euro zone bonds and will run into implacable German opposition that will squash the plan for now. But the plates are shifting and German Chancellor Angela Merkel looks somewhat isolated.
On euro bonds, Hollande can call on the support of Italy’s Mario Monti and the European Commission among others. Nonetheless, Angela holds the purse strings so while we will see some modest pro-growth measures agreed (and no doubt trumpeted), there will be no pump-priming that requires extra deficit spending, certainly no mutualising of debt and probably no hint that the likes of Greece and Spain will be given longer to make the cuts demanded of them (though that policy’s time could soon come, depending on how the June 17 Greek elections go).
Greek contagion aside, Spain remains the bloc’s biggest headache largely because of the weight of bad debts dragging its banking sector down. One idea is to allow the euro zone’s rescue funds to lend to banks direct, thereby removing the stigma of a government having to ask for aid. But Berlin is not keen on this one either.
Less controversial are plans to boost the capital of the European Investment Bank, use “project bonds” backed by the EU budget to invest in infrastructure and recalibrate some EU structural funds which has been used to help poorer EU members so that it is spent in other areas which might yield a quick growth dividend. None of that can hurt. But peashooters and elephants come to mind.
The golden rule of this crisis is that red lines have and will be crossed, most notably by Germany and the ECB, if the bloc is teetering right on the edge. The first ones to give this time may be on relaxing debt-cutting timeframes and allowing the bailout funds to help banks direct. Euro zone bonds remain a long way off (probably only when all member countries have got their deficits sustainably below 3 percent of GDP) and talk of a bloc-wide bank deposit guarantee fund isn’t anywhere near, though the pace of events could change that. Much hangs on how Greeks vote on June 17.
A demonstration of just how bent out of shape the euro zone is will be provided by today’s German 2-year debt auction. Yielding about 0.07 percent on the secondary market, that means Berlin has set a zero coupon for this sale and will pay no more to borrow this money over two years, yet investors are still expected to snap it up, such is the desperation for something secure. The debt agency says it is not planning to start offering negative coupons.
Germany’s zero bound
The ultra-low rates offered by two-year German bonds reflect just how worried investors have become about the euro zone debt crisis and the continent’s sluggish economy.
Two-year German debt is currently yielding only 0.09 percent. That is less than the 0.11 percent offered by equivalent bonds in Japan – whose central bank has been grappling with deflation for some two decades. It is also below the 0.26 percent offered by similar U.S. Treasuries after the Federal Reserve more than tripled the size of its balance sheet compared to pre-crisis levels.
Elwin de Groot, senior market economist at Rabobank, expects the euro zone’s sluggish economy and intractable debt crisis to continue to favour a safety bid as long as policymakers do not take steps towards a closer fiscal union. He sees the two-year German bond yield hitting zero in three to six months and ten-year benchmark yields falling to 1.40 percent over the same period from 1.59 percent currently.
Peter Allwright of investment management firm RWC Partners goes one step further. He can envision a scenario where the German Schatz trades at significantly negative yields as the crisis unfolds.
There is going to be a huge shortage of triple A collateral in euros and if people start to price in the euro break-up scenario, people are going to be pushed into that.
Euro election fever
We will return on Monday knowing whether the Greeks have elected a pro-bailout government and probably to find socialist Francois Hollande – the man leading the growth strategy charge – as the new French president.
An Hollande victory could cause some jitters given his rhetoric about the world of finance. But we’ve looked at this pretty forensically and there may not be much to scare the horses. Yes he is making growth a priority (but even the IMF is saying that’s a good idea) yet his only fiscal shift is to aim to balance the budget a year later than incumbent Nicolas Sarkozy would. Contrary to some reports, he is not intent on ripping up the EU’s fiscal pact and of course the bond market will only allow so much leeway.
The heavyweight Economist magazine may have labelled socialist Hollande “dangerous” but the reality is likely to be that he will rule from the centre and his demands for a dash for growth — and a change to the ECB’s mandate to aid it — will be tempered. Spain has shown everybody that too much fiscal loosening will be pounced upon by the bond market and while there is a lot of talk about a growth strategy for Europe, what we’ve heard so far amounts to tinkering.
While an Hollande victory looks priced in, Greece still has some power to shock the euro zone.
If the two main Greek parties – PASOK and New Democracy – fail to win enough votes to govern together, they may have to turn to a fringe anti-bailout party which would put a big question mark over Athens’ ability to stick with the austerity terms demanded by its international lenders. However, the threat of contagion, while still alive, has shrunk. With creditors already having taken a massive haircut, most non-Greek banks completely out or at least having written down anything they hold, a 500 billion euros rescue fund shortly to be in place and the IMF raising an extra $430 billion of its own, the power Greece has to start a domino effect in the euro zone is diminished. The caveat to that is, if it has to be cut some slack by the EU and IMF, Portugal and Ireland would presumably demand the same and then the whole austerity edifice starts to look wobbly again.
Despite the much vaunted growth strategy, the focus remains on structural reforms (which will take years to bear fruit) plus reconfiguring of some EU funds and a beefed up European Investment Bank. It will help, or at least can’t hurt, but what’s being discussed so far does not look like anything like a game changer, breaking the spiral of debt-cutting deepening economic downturns which in turn will make it yet harder to cut debt.
And those who really count — Merkel and Draghi at the top of the list — insist the austerity drive must not be dimmed. The markets would probably respond well to growth measures which did not undermine debt reduction. But that’s some trick.
Euro zone perspective – nowhere near out of the woods
After the Easter break, a bit of perspective — to paraphrase the immortal Spinal Tap, maybe too much perspective.
Over the past two weeks, Spanish and Italian borrowing costs have continued to rise – in the former’s case they have now relinquished more than half their fall since December and are heading back into the danger zone. Stocks have also appeared to have given up on their first quarter rally, presumably testament to the realization that the ECB and other top central banks are unlikely to be writing any more blank cheques for banks to reinvest.
Late last year, it was Italy that seemed to have the power to drag Spain into the debt crisis mire. Now, it’s the other way round and after the ECB anaesthesia wears off, it’s clear the euro zone patient is still sickly.
The European Commission will cast an eye over Spanish budget plans at some point this week. Spanish risk premiums have leapt since Prime Minister Mariano Rajoy defied Europe in early March by unilaterally easing Madrid’s 2012 deficit target. The silver lining for Madrid is that it has taken advantage of the benign market conditions early in the year to clear almost half its 2012 debt issuance needs and Rajoy is pushing through sweeping labour reforms and savage spending cuts. The trouble is that policy mix is likely to drive Spain further into recession – a recipe for debt to rise not fall.
Approaching elections in Greece and France throw further uncertainty into the mix. The former could weaken austerity resolve and the latter may elect a socialist president intent on rewriting the bloc’s new fiscal rules.
After weak U.S. jobs data on Friday, even a surprise Chinese trade surplus in March – suggesting it’s fabled soft landing is on track – has failed to lift equities. European stocks have dropped more than one percent in early post-holiday trade and safe haven German Bunds have jumped at the open with yields at their lowest level since September. For the first time this year, the markets have reverted to a glass half empty rather than half full bent.
The U.S. data overhang continues to be the strongest driver for now but a wobbly Spanish bond auction last week is also fresh in investors’ memories, given a big Italian debt sale looms on Thursday.
This week in the euro zone
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.
Bundesbank chief Jens Weidmann has been leading a push by a group of ECB policymakers for the bank to prepare for a shift to exit mode just a month after it completed the second of the lending operations. His ECB boss, Mario Draghi, is more relaxed and it is highly unlikely that the ECB will change course for several months yet and quite possibly not this year.
That applies in spades to the Bank of England. BoE Governor Mervyn King sat firmly on the fence last week, saying he did not know whether more QE would be required in Britain or not. King illuminated the other common theme coming from central bankers, saying the onus was firmly on the politicians now. The major western central banks seem to be in a holding pattern, disinclined to provide yet more stimulus yet viewing their economies as far too fragile to hit the policy reverse switch.
For investors pondering whether they could be derailed by a burgeoning economic slowdown, euro zone and UK purchasing managers’ indices – which have a strong correlation with GDP – will be a must-watch as will equivalent reports from China. Spain will hold a pre-Easter bond auction. The glut of ECB money has helped Italian and Spanish debt sales go down a storm in the first quarter of the year – banishing the fear about their refinancing mountains – and that effect is likely to persist for some time yet, though not forever.
The ECB’s dramatic intervention and the debatable move by euro zone leaders to create a more potent rescue fund from mid-year buys time, but no more than that, for governments to push through structural reforms to make their economies more competitive and balance the need to cut debt while not snuffing out growth, a balancing act that has not been achieved so far. Until that is done, the underlying fault lines remain.
Today in the euro zone – a blizzard of bailout numbers
Brace yourself for a blizzard of numbers.
EU finance ministers gathered in Copenhagen are poised to decide precisely how much firepower their new rescue fund – to be launched mid-year – will have. A draft communiqué suggests that as of mid-2013, presuming no new bailouts have been required in the interim, the combined lending ceiling of the future ESM and existing EFSF bailout funds will be set at 700 billion euros (500 billion pledged to the ESM plus the roughly 200 billion already committed to Greek, Irish and Portuguese rescue programmes).
Up to mid-2013, if 700 billion proves to be insufficient — i.e. someone else needs bailing out — euro zone leaders will be able to bolster it with the 240 billion euros as yet unused in the EFSF, according to the draft, although German Finance Minister Wolfgang Schaeuble said last night that 800 billion should be the absolute limit.
Sorry, there’s more. Because the ESM will not have its full 500 billion euros capacity on day one – it will build up over time – the real available figure for the next year is more like 640 billion euros. Confused? You should be.
Nonetheless, this is probably sellable by Angela Merkel to German MPs and her public as not being a real increase at all (which is not that far from the truth) while also probably being enough for Christine Lagarde to seek greater crisis-fighting funds for the IMF from its non-European members, most of whom have said they would provide nothing until the euro zone shows some serious intent of its own. The IMF spring meeting looms next month.
The big question is, is it enough to keep markets calm? The possibility of drawing on the extra 240 billion over the next year might do the trick but it’s not yet guaranteed that that will be agreed. If the ministers only offer up a 500 billion fund plus the money already committed to bailouts (which really is not new money at all), there could well be a wobble. The other big setpiece of the day is the Spanish budget, which Rajoy insists will be tough. Markets are watching closely. Spain reported a budget shortfall of 8.5 percent of GDP in 2011 and faces a target of 3 percent next year. It can ill-afford any slippage; its bond yields have already started rising since Prime Minister Mariano Rajoy rejected the first 2012 target agreed with the European Commission and secured a softer goal.
Rajoy has promised a tough budget which economists predict will push Spain into a pretty deep recession this year. The government believes 35 billion euros of cuts will allow it to meet its deficit targets but given an economic downturn will cut government revenues, some analysts estimate nearly double that amount will be needed. The outside pressure for reform is unrelenting. Schaeuble said a youth unemployment rate nearing 50 percent was little surprise considering the state of Spanish labour laws.
Euro zone week ahead – Spain budgets and Italy labours
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.
Many in the euro zone want the resources of the EFSF bailout fund to be rolled into its successor, the ESM, creating a 750 billion euros pool which may be enough to scare the markets off from attacking Italy and Spain, particularly if the IMF flexes its muscles too. A decision could be made in Copenhagen though Germany continues to resist. The most likely solution is the least ambitious one – an increase of the bailout capacity to 692 billion (500 billion from the ESM, to be reached gradually over four years + 192 bln of money already committed to the Greek, Irish and Portuguese programmes by the EFSF).
The other key ingredient is public willingness to tolerate years more economic pain. The Portuguese have held a strike and Spaniards will do so this week, with and Italian down-tools also looming. So far, protest has been sufficiently muted that politicians have not been deflected from their cuts and reforms programmes. Spain’s ruling PP is likely to win an Andalusian election over the weekend, a victory which may encourage it to extend its austerity drive.
Spanish borrowing costs have started rising appreciably since its deficit spat with Brussels. 10-year yields are back above 5.5 percent, nearly a point above their low point two months ago.
In Italy, Prime Minister Mario Monti still faces a battle over labour reforms which will go to parliament. Any significant dilution would be taken badly by the markets though ministers are talking tough “back us or sack us” rhetoric and none of the parties have a vested interest in collapsing the government and having to pick up the pieces in the current environment. Italian debt auctions over the week should pass smoothly nonetheless.
The euro zone today – strikes, reform and recession
The euro zone economy looks to have contracted at a faster pace in March, according to the latest purchasing managers’ data, hours after ECB President Mario Draghi declared the worst of the debt crisis to be over. A mild recession appears to be in prospect with the probable exception of Germany.
The two aren’t mutually exclusive. Even if the existential threat to the currency bloc has passed, many of its members face years of economic hardship yet. With China’s equivalent report also coming in weak, the short-term signs are not auspicous.
Italy’s largest trade union has called a strike for the near future over Prime Minister Mario Monti’s labour reforms which have been rehardened to make it easier to fire not just workers in new jobs but right across the labour force. The prime minister says he won’t negotiate further given he has the support of other unions as well as employers groups. However, there is room for “fine tuning” today and tomorrow. The CGIL union has called for an eight-hour general strike with more to follow.
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 third largest economy fell over, the currency bloc really would be on the skids.
Monti must convince markets – which continue to give him the benefit of the doubt 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.
Today, bailed out Portugal also faces a general strike protesting at austerity measures which the government is doing its best to stick to, without much prospect that it will turn the economy around. Data on Wednesday, showed Portugal’s core public deficit nearly tripled in the first two months of 2012, showing a deepening economic slump is denting tax collection and stoking concerns it will follow Greece in requiring more rescue funds. The difference is there is much greater euro zone goodwill towards Lisbon, so those funds will be provided without much grumbling.
Ireland, the country that seems to have a chance of riding the austerity wave successfully, produces Q4 GDP data which will show whether the government met its 1 percent growth target next year, while Germany continues to look like an economy on a different planet to its currency peers. It expects to balance its budget for the first time in more than 40 years in 2016 thanks to strong growth and full tax coffers.
A recovery in Europe? Really?
There’s a sense of relief among European policymakers that the worst of the euro zone’s crisis appears to have passed. Olli Rehn, the EU’s top economic officials, talked this week of a “turning of the tide in the coming months”. Mario Draghi, the president of the European Central Bank, speaks of “sizeable progress” and “a reassuring picture”.
At last week’s spring summit, EU leaders couldn’t say it enough: “This meeting is not a crisis meeting … it’s not crisis management,” according to Finnish Prime Minister Jyrki Katainen. All the talk is of how the euro zone’s economy will recover in the second half of this year.
But for the 330 million Europeans who make up the euro zone, the outlook has, if anything, darkened. As euro zone governments deepen their commitment to deficit-cutting, and rising oil prices mean higher-than-expected inflation, households can’t be counted on to drive growth. Not only did housing spending fall 0.4 percent in the October to December period from the third quarter, but unemployment rose to its highest since late 1997 in January.
Joblessness is reaching shameful levels in southern Europe. In Greece, unemployment rose to a new record high of 21 percent in December and to 23 percent in Spain in January. Even in wealthy, northern Europe, the number of people out of work has started to rise in France, the Netherlands and Germany.
Just over half of the euro zone‘s economic output is generated by domestic consumer spending, but demand for goods looks chronically weak and fiscal austerity is aggravating the situation. Euro zone governments, desperate to distinguish themselves from debt-stricken Greece, are completely unwilling to step in and spend. The European Commission, persuaded mainly by Germany that fiscal discipline will lift economic growth, is on their backs to get their deficits within the 3 percent level of GDP by the end of 2013.
“The case against Europe’s growth strategy is that it is all supply and no demand,” said Philip Whyte, a senior research fellow at the Centre for European Reform. “Fiscal policy is being tightened too rapidly. The more certain EU countries do to balance their budgets, the more output contracts,” he said in a recent paper.
So where will growth come from? The ECB’s Draghi said this week he is counting on foreign demand. Emerging Asia and a stronger recovery in the United States might help pull the euro zone out of its slump. But with Germany responsible for almost 40 percent of the euro zone’s exports, a wider tide of prosperity across the currency area looks unlikely.
Why Germany doesn’t want euro zone bonds
Ever wanted to know why Germany is not keen on single euro zone bonds? Look no further:
