MacroScope

After the EU summit exceeded expectations the more considered verdict of the markets will dictate in the short-term, certainly until the European Central Bank’s policy meeting on Thursday. Previous summit deals crumbled pretty quickly buying only a few days or even hours of market relief.

After strong gains on Friday, Asian stocks are up modestly and European shares have edged higher. However, German Bund futures are nearly half a point higher, so something’s got to give and more often than not it’s the stock market that thinks again. So maybe Friday’s rally was a one-off.

For it to have any legs, the ECB may well have to come up with something on Thursday, and a quarter-point rate cut – widely priced in – may not be enough. ECB policymaker Asmussen is already out saying Greece must should not loosen its bailout programme, Spain can restore confidence with a bank recap plan that builds in a large margin for error and dismissing calls for the ESM rescue fund, which comes into being next week, to get a banking licence so it could draw on virtually unlimited ECB funds. That all sounds fairly uncompromising.

No one is getting carried away. The agreement in Brussels to accelerate progress towards cross-border banking supervision after which the ESM rescue fund will be allowed to directly inject capital into banks was a big deal for Spain since it will keep its bank bailout of up to 100 billion euros off the government’s wilting balance sheet. The agreement that the ESM would not have preferred creditor status for Spanish loans, something that had spooked private investors who would have dropped to the bottom of the repayment pecking order, is also significant and will surely set a precedent.

But Spain remains in a whole heap trouble – deep in recession, unlikely to meet its deficit targets this year and facing some daunting looking debt refunding humps in the next few months.

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.

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 well and truly a Spain day.
Its 10-year yields may have ducked back below the 7 percent pain threshold but Madrid’s auction of two-, three- and five-year bonds could still be tricky. It is only aiming to sell up to 2 billion euros and should manage to thanks largely to weak Spanish banks buying them up but the five-year bond is likely to command yields last seen in 1996.

After that, an independent audit of Spain’s stricken banking sector is due to be published which will give a guide as to how much of the 100 billion euros offered by the euro zone the banks need to take to be recapitalized. Madrid may then make a formal request for aid at a meeting of euro zone finance ministers later in the day. We’ve had from sources that the audit will say up to 70 billion euros is needed but Spain would be well advised to take more to try and convince markets that it has all bases covered.

The audit is expected to divide the banks into three groups: the weakest regional savings banks heavily exposed to bad property debts, a group of mid-sized banks which face temporary liquidity problems and two ‘good’ banks – BBVA and Santander – that won’t need any help.

The G20 summit may have marginally exceeded the lowest common denominator of expectations with euro zone leaders pledging to work on integration of their banking sectors as part of a push towards fiscal union. But it’s not clear that a banking union will happen any quicker than we thought before.

Germany is happy for cross-border oversight, maybe in the hands of the European Central Bank, to be zipped through but on the really vital parts of the structure – particularly a deposit guarantee scheme to guard against bank runs – it has clearly said it would only be possible once the drive towards fiscal union is set in stone. It will also not countenance mutual debt issuance until the fiscal union is in place.

Onus was put on next week’s EU summit to put flesh on the bones, although no definitive decisions are expected there and EU Commision President Barroso he would present its plan on banking integration in September. Here’s the reality check: European Council President Van Rompuy spelled out the vision of a much deeper economic union to underline the irreversibility of the euro project and said it would take less than the 10 years that ECB chief Draghi has talked about. And for many countries, particularly France, the surrender of that much sovereignty will be very hard to take.

There’s a high degree of battening down the hatches going on before the Greek election by policymakers and market in case a hurricane results.

G20 sources told us last night that the major central banks would be prepared to take coordinated action to stabilize markets if necessary –- which I guess is always the case –  the Bank of England said it would  flood Britain’s banks with more than 100 billion pounds to try and get them to lend into the real economy and we broke news that the euro zone finance ministers will hold a conference call on Sunday evening to discuss the election results – all this as the world’s leaders gather in Mexico for a G20 summit starting on Monday.
Bank of England Governor Mervyn King said the euro zone malaise was creating a broader crisis of confidence.

The central banks acted in concert after the collapse of Lehmans in 2008, pumping vast amounts of liquidity into the world economy and slashing interest rates. There is much less scope on the latter now. The biggest onus may fall on the European Central Bank which may have to act to prop up Greek banks and maybe banks in other “periphery” countries too although the structures to do so through the Greek central bank are in place and functioning daily. In extremis, we can expect Japan and Switzerland to act to keep a cap on their currencies too. As a euro zone official said last night, a bank run might not even be that visible and start on Sunday night over the internet rather than with queues of people outside their local bank on Monday morning.

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.

Italy, rapidly moving centre stage after the euro zone’s failure to assuage markets with a 100 billion euros Spanish bank bailout, faces a crunch bond auction. Having paid four percent to borrow for a year yesterday, it is likely to fork out over five percent for three-year paper although the smaller than usual target of up to 4.5 billion euros means the sale should get away. It will also issue a smattering of 2019 and 202 bonds.

Technocrat prime minister Mario Monti’s honeymoon period is over with even some he would have considered allies decrying the slow pace of his reform programme. Already this week he has appealed to Italy’s fractious political parties for support in keeping the austerity show on the road.
Today, Monti hosts France’s Francois Hollande. They agree on a lot – the need for a stronger growth strategy, a banking union established sooner rather than later and a longer-term goal of euro zone bonds. Berlin, with the possible exception of the first goal, definitely does not.

Moody’s slashed Spain’s rating to just one notch above junk last night. The power of the ratings agencies to shock is significantly diminished but if Spain’s sovereign rating drops further, more of whatever non-Spanish bank private investors are left will be forced to head for the exits. Moody’s noted that the bank bailout will increase Spain’s debt burden and the dangerous of loop of damaged banks being the main buyers of Spanish government debt which is falling in value. It repeated its warning that euro zone ratings could be cut further if Sunday’s Greek election were to increase the chances of that country leaving the euro.

The law of diminishing returns?
The first euro zone bailout, of Greece, bought a few months of respite, the next ones bought weeks, latterly it was days. Now … hours. Spanish bond yields ended higher on the day and, more worryingly, Italy’s 10-year broke above six percent. It was always unlikely the deal to revive Spanish banks was going to lead to a durable market rally with make-or-break Greek elections looming on Sunday but there were other things at play.

Top of the list is that the bailout will inflate Spain’s public debt and the dangerous loop of damaged banks buying Spanish government bonds that are falling in value. There’s also the fact that Germany and others are keen to use the new ESM rescue fund to funnel money to Spain because of the greater flexibility it offers. That will make private investors subordinate to the ESM which could prompt another rush for the exits which Madrid can ill afford since this is the first euro zone bailout which keeps the recipient active in the bond market.
It’s for the same reason that a revival of the ECB’s bond-buying programme, which it still doesn’t fancy, could prove counter-productive.

Officials are already pondering that conundrum, suggesting that the loan to Spain could initially be made under the existing EFSF bailout fund then taken over by the ESM, though that sounds like the sort of creative thinking in Brussels that generally fails to convince investors.
Another cracking Retuers exclusive following our breaking of the Spanish bailout on Friday, showing European finance officials have discussed limiting the size of withdrawals from ATM machines, imposing border checks and introducing euro zone capital controls as a worst-case scenario should Athens decide to leave the euro, is unlikely to have settle market nerves.