MacroScope

There is an unusually public level of disagreement going into a key euro zone meeting. EU leaders aren’t helping to foster a sense of united purpose which could calm investors a little.

Yesterday, Germany’s Angela Merkel said Europe would not share debt liability as long as she lived. Maybe she was playing to a domestic audience, but if she means it, one of the main planks of a structure that could eventually solve this crisis has just been reduced to ashes. On the other side of the fence, Italy’s Monti said he was in no mood to rubber stamp any conclusions in Brussels. He said the summit promised to be “very difficult”. Spain’s Rajoy is in accord with him.

There may be movement in other areas though with Merkel’s coalition parties suggesting the ESM rescue fund could lend direct to banks, which would remove the stigma from the Spanish government of having to ask for aid and may explain why Madrid has been dragging its feet over a bank bailout of up to 100 billion euros, waiting for something better to come along.

More significantly, a senior lawmaker in Merkel’s party said the ESM could have its preferred creditor status removed. Technical perhaps, but a big deal since as things stand if the rescue fund offers a bailout or buys up bonds it could drive private investors out since they would be last to get paid back in the event of a default. Removing that obstacle could go some way to improving sentiment about Spain. However, we need to hear more senior voices in favour before this moves from the possible to the probable. Euro zone finance ministers will hold a conference call on the Spanish package and the Cypriot bailout request later today.

The leader of Germany’s opposition SPD is in the FT calling for urgent measures to lower euro zone borrowing costs. Monti wants the euro zone rescue funds to be used to help limit the spreads over German Bunds on bonds issued by countries that respect EU budget rules.  Support for his structural reform programme is waning at home and Italy’s parties have made it clear he needs to return from Brussels with some sort of trophy.

Cyprus became the fifth euro zone country to seek a bailout last night though its needs – maybe up to 10 billion euros – will not put a dent in the currency bloc’s resources. We’re still waiting to see precisely how much money Spain will take for its banks of the 100 billion euros offered. Moody’s cut the ratings of 28 of 33 Spanish banks by one to four notches last night, an inevitable consequence of the sovereign downgrade earlier this month.

Markets seems to have decided that they will be disappointed by the crunch summit at the end of the week. There was a somewhat discordant meeting between the big four euro zone leaders on Friday, with Germany’s Merkel refusing to budge in key areas, but she and French President Francois Hollande have the chance to strike a more positive note when they meet bilaterally on Wednesday abnd hot off the press we have a meeting of the finance ministers of Germany, France, Italy and Spain this evening — so maybe there is a concerted effort to get on the same page.

Lael Brainard, the U.S. Treasury guru who liaises with Europe, spoke for the rest of the world when she told us in an interview that EU leaders had to put “more flesh on the bone” of their ideas to resolve the crisis.

The euro zone’s big four meet in Rome with Germany’s Angela Merkel likely to come under pressure from Italy’s Mario Monti, Spain’s Mariano Rajoy and France’s Francois Hollande to loosen her purse strings and principles.

Monti, with Hollande’s backing, has suggested using the euro zone rescue funds to buy Spanish and Italian bonds but Berlin is not keen and there are good reasons why it might not work, not least the ESM’s preferred creditor status which means that if it piled in, private investors may flee knowing they would be paid back last in the event of a default.

The Eurogroup may have skirted the same problem with regard to the Spanish banking bailout last night by deciding to start the loans via the existing EFSF, which does not have seniority, before switching to the ESM. The EFSF’s rules will persist throughout.

It’s already been established that economists’ predictions about the euro zone’s future hinge largely on where their employer is based. Euro zone optimists tend to work for euro zone banks and research houses, and euro zone sceptics for companies based outside the currency union.

It somewhat undermined the idea their analyses are based purely on hard-headed economics, and less on national factors.

There was an echo of that in this week’s of economists and fixed income strategists, who were asked whether they expect euro zone leaders will agree to the issuance of a common euro zone bond, as backed by new French President Francois Hollande.

There was no Greek relief rally (though at least we had no meltdown) and Spanish 10-year yields shot back above seven percent as a result, setting a nasty backdrop to today’s sale of up to 3 billion euros of 12- and 18-month T-bills.

Madrid has had little problem selling debt so far, particularly shorter-dated paper, but it’s beginning to look like the treasury minister’s slightly premature assessment two weeks ago that the bond market was closing to Spain is beginning to come true.
The 12-month bill was trading on Monday at around 4.9 percent. As last month’s auction it went for a touch under three percent. If that is not hairy enough, Spain will return to the market on Thursday with a sale of two-, three- and five-year bonds.

We’re still awaiting the independent audits of Spain’s banks which will give a guide as to how much of the 100 billion euros bailout offered by the euro zone they need. Treasury Minister Montoro was out again yesterday, pleading for the ECB to step in – presumably by reviving its bond-buying programme – something it remains reluctant to do, although a strong sense of purpose and commitment on economic union at the EU summit in a fortnight could embolden the central bank to act.

German Bund futures have just had their second straight week of losses. This has left many scratching their heads given the timing – right before Greek elections that could decide the country’s future in the euro and the next phase of the euro zone debt crisis. That sort of uncertainty would normally bolster bunds, which are seen as a safe-haven because of the country’s economic strength.

To explain the move, analysts pointed to profit-taking on recent hefty gains, and to a bout of long-dated supply from highly-rated Austria, the Netherlands and the European Financial Stability Fund this week. They also noted changes in Danish pension fund rules as an additional technical factor reducing demand for longer-dated German debt.

The losses, however, have also prompted some debate about whether contagion is spreading to Germany, the euro zone’s largest economy.

Despite all their years of experience and complex mathematical models, for economists the question of the euro zone’s survival really has them at the mercy of national bias… at least in terms of where their employer is based.

One of the key points from the latest Reuters poll was that a majority of economists from banks and research houses around the world – 37 out of 59 – expect the euro zone to survive in its current form for the next 12 months.

But behind that headline figure, the answers were skewed heavily by region.

Only 5 out of 24 economists from organisations based inside the euro zone thought it would fail to survive in its present 17-nation form over the next 12 months.

Throughout Europe’s financial crisis, German government bonds have been seen as a safe-haven for those seeking protection against the troubles of southern Europe. However, the confidence of financial markets in Germany’s finances may finally be starting to falter as the cost of a festering financial crisis rises – and the country is seen as ultimately holding the bag.

Demand at the latest government bond auction remained solid. However, the slide in German bunds continued into a second day and, worryingly, it was driven in part by worries about contagion after Spain’s poorly-received 100 billion euro bank bailout.

According to Capital Economics:

The last few days have brought clear signs that bunds are finally losing their safe-haven status.

Things are on the move in Spain although nothing is set in stone yet.
Treasury minister Montoro’s call yesterday for “European mechanisms” to be involved in the recapitalization of Spain’s debt-laden banks – a reversal of Madrid’s previous insistence that it could sort its banks alone – unleashed a barrage of whispers in Europe’s corridors of powers.

Our sources say that the independent of audit of Spanish banks’ capital needs, the first phase of which is due by the end of the month, will be a key moment after which things could move quickly.

The hitch is that Madrid still doesn’t want the humiliation of asking for a bailout and Germany will not countenance the bloc’s rescue funds lending to banks direct. One possible solution floated last night –  the EFSF or ESM bailout funds could lend to Spain’s FROB bank rescue fund, which could be viewed as tantamount to lending to the state but would give the government some political cover to say it wasn’t asking for the money. This is anything but a done deal and there would still be some strings attached which could be tough for Prime Mininster Mariano Rajoy to swallow.

Many market analysts consider a deeper fiscal union the only way to hold together a troubled euro zone. And while Germany continues to loudly reaffirm its long-standing opposition to shared euro zone bonds, the region is in many ways already headed towards implicit mutual responsibility for national debts. Berlin will likely come under increasing pressure to succumb, especially now that “core” European countries are entering the crosshairs of speculators .

The region’s complex TARGET2 payments system, which hosts payment flows between euro zone member states, suggests there is already a good deal of risk-sharing implicit in regional structures, not to mention the exposure the European Central Bank has to peripheral debt. That shared liability may fall short of the kind of joint risk-taking foreseen for a common bond, where one country is responsible for the non-payment of debt by another.

But analysts say the build-up of imbalances in the system – as the ECB replaced private sector lending which dried up for peripheral countries – reflects the latest in a number of crisis-fighting steps that have increased regional integration.